What investors should watch in Microsoft’s year-end results

Microsoft did investors a couple of favours when it released its year-end results in August. The company adopted two significant new accounting rules early, and also dropped the practice of reporting non-GAAP earnings.

Motivated to lead

We’ve mentioned the notable changes coming to accounting rules for revenue recognition and leases before. Now, Microsoft is one of the first major companies to reveal how the changes look in practice.

Because Microsoft’s fiscal year-end falls in June, the company didn’t have to report using the new revenue rules until after June 30, 2018, or use the new lease rules until after June 30, 2019.

Microsoft decided to adopt the rules early for a few reasons. The new revenue rules made the company’s GAAP results look better, which also motivated Microsoft to drop its non-GAAP reporting, as the difference between the two figures shrunk significantly.

Further, Microsoft’s revenue and income (and those of other licensing vendors) under the new accounting rules are more easily compared with cloud-based software vendors, which might help with valuation.

The reason for adopting the lease rules two years early was so the company could make all of its accounting changes and restatements at once, and start moving forward with more comparable results and less reporting volatility and uncertainty.

Because Microsoft is large, and watched closely by the market, you can expect many U.S. and Canadian companies to mimic the company’s disclosure and reporting choices regarding the new rules.

Found revenue

The new revenue rules will have a significant impact on certain industries, especially where revenue and cash flows from a specific transaction are spread over several years, or where hardware, software, servicing, support and warranties are mixed together.

For Microsoft, the changes substantially impact its financials in a few key areas, including Windows 10 original equipment manufacturer revenue and the licensing component of on-premises annuity contracts. Generally, the company recognizes more revenue on the delivery of software (save for upgrades), instead of smoothing revenue over time or matching it to cash flow. This method accelerates revenue recognition and introduces more volatility and seasonality.

Table 1 shows key figures for the 2017 fiscal year under both sets of accounting rules. GAAP revenue increases 7.3% under the new rules and, with little change in expenses (aside from tax), much of that revenue flows to the bottom line, boosting diluted EPS by 20%.

While these changes are significant, Microsoft had readied the market to a certain degree over the last few years by reporting non-GAAP revenues that more closely approximated its sales under the new accounting guidelines.

Non-GAAP and non-IFRS earnings have become banes for investors. They represent a slippery slope, with some executives sliding all the way to the bottom in an effort to boost the appearance of company earnings. While this isn’t the case for Microsoft, the market as a whole benefits when a major market constituent eliminates its non-GAAP reporting.

Table 1: Microsoft summary income statement, fiscal 2017 (US$ billions, except EPS)

	Old rules	New rules	Difference
Revenue	$90.0	$96.6	+7.3%
Gross margin	$55.7	$62.3	+11.8%
Operating income	$22.3	$29.0	+30.0%
Net income	$21.2	$25.5	+20.3%
Diluted EPS	$2.71	$3.25	+20.0%

Sources: Microsoft, Accountability Research

A new look for leases

The new rules for leases will significantly impact companies, but their effects are less understood at this point since mandatory implementation won’t go into effect until a year after the rules for revenue.

Under the new rules, the vast majority of leases currently classified as operating leases must be reported on the balance sheet, similar to existing capital or finance leases. For Microsoft, this includes recording assets and liabilities corresponding to leases for data centres, R&D facilities, retail stores and certain equipment.

Table 2 shows that, under the new rules, the company is adding US$6.6 billion in both operating lease assets and liabilities, increasing long-term assets by 7.9%. The impact on total assets isn’t great because the company has a large hoard of cash and short-term investments. The impact on total liabilities and equity (not shown) is less apparent since the new revenue rules significantly reduce unearned revenue liabilities. Also not obvious is that Microsoft’s leverage increased slightly and its return on assets decreased because of the new lease rules.

Microsoft provides a good first look at the impact of the new lease rules in action. It’s not hard to imagine the effect they could have on companies with a higher proportion of operating leases to total assets, and what that could mean for perceived leverage and efficiency ratios. The rules will also reset what investors believe are normal historical ratios.

Table 2: Microsoft summary balance sheet, fiscal 2017 (US$ billions)

	Old rules	New rules	Difference
Operating lease assets	$0	$6.6	+$6.6
Long-term assets*	$81.2	$87.6	+7.9%
Total assets*	$241.1	$250.3	+3.8%
Operating lease liabilities	$0	$6.6	+$6.6

* Includes impact of new revenue rules

Sources: Microsoft, Accountability Research