Free Windows 10 is not an upgrade ... it's marketing

Windows 10 is not a free upgrade. It's a "marketing and promotional activity," as far as Microsoft is concerned.

Windows 10 is not a free upgrade, Microsoft said last week. It's a "marketing and promotional activity."

The odd nomenclature appeared in Microsoft's 10-Q filing with the US Securities and Exchange Commission (SEC) that highlighted the company's first quarter financial numbers.

In the 10-Q segment devoted to revenue recognition - typically several paragraphs of static boilerplate - Microsoft brought up Windows 10, specifically the free upgrade it plans to hand out to users of Windows 7 and Windows 8.1 after Windows 10's summer debut.

"This offer differs from historical offers preceding the launch of new versions of Windows as it is being made available for free to existing users in addition to new customers after the offer announcement," Microsoft said.

"We evaluated the nature and accounting treatment of the Windows 10 offer and determined that it represents a marketing and promotional activity, in part because the offer is being made available for free to existing users [emphasis added]."

There was method to Microsoft's apparent madness.

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 8.1 -- then recognize that revenue only when the upgrade is released. All the revenue from the software sale is eventually booked, but at staggered intervals.

Once one got past the accounting-speak, Microsoft made that clear in the 10-Q.

"As this is a marketing and promotional activity, revenue recognition of new sales of Windows 8 will continue to be recognized as delivered," the company said. That meant sales of Windows 8.1 licenses to OEMs [original equipment manufacturers] will be recorded immediately and in full, not in fragments with some deferred until Windows 10 launches and the free upgrade is available to customers.

The difference for Microsoft? If it said Windows 10 was an upgrade, not part of a marketing campaign, the company would have had to adjust Windows revenue to account for the deferrals -- and set aside money from sales of the OS starting in January when it announced the no-cost upgrade -- reducing Windows' earnings for at least the first half of this year, perhaps longer.

That could have painted an even darker picture of Windows revenue, maybe one that would have bothered skittish short-term investors enough to impact the stock. After all, Windows revenue is already on a downward trend: In Q1 2015, sales to OEMs of consumer licenses -- those most affected by the free Windows 10 offer -- were off 26% from the year before.

By deferring revenue, those numbers would have looked even worse.

There has been precedent for Microsoft's working the language like this.

In 2013, Microsoft said Windows 8.1 -- the major refresh to the original Windows 8 of the year before -- was not an upgrade but was instead an update, again for accounting purposes. Like Windows 10 will be, Windows 8.1 was given to customers free of charge.

"We evaluated Windows 8.1 and determined that it did not meet the definition of an upgrade and thus have not deferred revenue related to this planned release," Microsoft said at the time in another SEC filing.

To get a rough idea of how much Microsoft might have had to defer if it had not labeled Windows 10's upgrade a promotional deal, one has only to look to the past.

The last time Microsoft offered a discounted upgrade to customers was prior to the launch of Windows 8. During an eight-month stretch from early June 2012 to the end of January 2013, people who purchased a new PC pre-loaded with Windows 7 were eligible for a $15 upgrade to Windows 8 Pro.

Microsoft deferred just under $1.1 billion in revenue for that upgrade program over a three-quarter stretch, then recorded that money as income during the first quarter of 2013.

Without access to Microsoft's own calculations, it's impossible to know how much it would have had to defer had the company not dubbed the free Windows 10 a promotion. Although fewer Windows PCs are sold these days than in 2012, the free-versus-$15 part of the equation may have made the deferred amount similar to the one for Windows 7.

Also unknown is whether Microsoft will defer revenue earned from Windows 10 licenses sold to OEMs to account for the plan to provide free updates and upgrades for, as the company has cryptically said, the "supported lifetime of the device." Microsoft has yet to define what it means by that phrase.

For the moment, all that's clear is that the Windows 10 free upgrade is not an upgrade: It's a marketing and promotional activity.

Keep that in mind when Windows 10 boots for the first time.

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