Question

Income Measurement/Revenue Recognition A. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) came together on a unified project to outline the accounting principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP and IFRS. Research IAS-18, Revenue, and discuss how it would apply to AMAZON. B. Review AMAZON's revenue over the past two years. Analyze the change in revenue (increase/decrease) and give the reasons for this change. C. Reflecting upon AMAZON's balance sheet, identify the unearned revenue accounts listed. How does AMAZON handle the proper accounting treatment with regard to recognizing revenue from unearned revenue accounts?

Answer 1

Revenue Recognition Accounting Policy

Amazon.com recognizes revenue from product sales or services rendered when the following four criteria are met: persuasive evidence of an arrangement exists, delivery has occurred or service has been rendered, the selling price is fixed or determinable, and collectability is reasonably assured. Revenue arrangements with multiple deliverables are divided into separate units and revenue is allocated using estimated selling prices if Amazon.com does not have vendor-specific objective evidence or third-party evidence of the selling prices of the deliverables. Amazon.com allocates the arrangement price to each of the elements based on the relative selling prices of each element. Estimated selling prices are management's best estimates of the prices that Amazon.com would charge the customers if Amazon.com was to sell the standalone elements separately and include considerations of customer demand, prices charged by Amazon.com and others for similar deliverables, and the price if largely based on the cost of producing the product or service.

Return allowances, which reduce revenue and cost of sales, are estimated using historical experience. Allowance for returns was $153 million, $156 million, and $62 million as of December 31, 2015, 2016, and 2017. Additions to the allowance were $1.3 billion, $1.5 billion, and $1.8 billion, and deductions to the allowance were $1.3 billion, $1.5 billion, and $1.9 billion in 2015, 2016, and 2017. Revenue from product sales and services rendered is recorded net of sales and consumption taxes. Additionally, Amazon.com periodically provides incentive offers to the customers to encourage purchases. Such offers include current discount offers, such as percentage discounts off current purchases, inducement offers, such as offers for future discounts subject to a minimum current purchase, and other similar offers. Current discount offers, when accepted by Amazon.com's customers, are treated as a reduction to the purchase price of the related transaction, while inducement offers, when accepted by the customers, are treated as a reduction to purchase price based on estimated future redemption rates. Redemption rates are estimated using Amazon.com's historical experience for similar inducement offers. Current discount offers and inducement offers are presented as a net amount in "Total net sales."

Unearned revenue represents the amount the company receives in advance of providing its service, and a fixed portion of it gets recognized as revenue, as the service gets delivered.

Amazon's unearned revenue is mostly comprised of the $99 Prime annual fee from both new and renewing subscribers. Amazon collects the annual fee upfront and then recognizes 1/12th of the $99 fee every month as revenue.

Due to accrual accounting, revenue can only be recognized during the period in which it is earned. That means any Prime membership fee or AWS booking fee cannot be fully booked as revenue in the period in which the sale is made

"Unearned revenue is recorded when payments are received in advance of performing our service obligations and is recognized over the service period. Unearned revenue primarily relates to prepayments of Amazon Prime memberships and AWS services." - Amazon 2016 10-K

Additions to unearned revenue include cash received for services not yet performed, while amortization of previously unearned revenue represents the revenues actually booked in the period in which the service is rendered...

...Much like how backlog is a forward indicator of an industrial company's revenue, unearned revenue represents future revenues for the company and should be emphasized when analyzing the company's actual growth. Furthermore, unearned revenue represents cash inflows to the company, therefore it is critical for valuing the company using DCF...

...As Prime membership and AWS users increase, the portion of unearned revenue, as a percentage of Amazon's overall revenue, has increased, making it a more important measure of Amazon's true revenue as time goes on...

For the first time since Q4 of 2013, net unearned revenue was negative:

Even though Q2 had historical been the quarter with the lowest or second lowest net unearned revenue, there has never been a decline as significant as Q2 2017.

Furthermore, because net unearned revenue is increasing as a proportion of GAAP net revenue due to the shift of a higher proportion of their sales to subscription-based (Prime and AWS), the sudden drastic decline in unearned revenue is now much more concerning than ever before because it represents a higher proportion of their business and serves as a forward indicator of future revenues.

Given the importance of this number, the question now is, what caused the sudden drastic decline?

This chart nicely explains why net unearned revenue suddenly turned negative this quarter. Growth in additions to unearned revenue had historically been in the 50-80% range (which reflects the explosive growth in Prime and AWS), but this growth suddenly slowed to 45% in Q1 2017 and slowed further to 30% in Q2 2017. As a result, growth in additions to unearned revenue was not sufficient to exceed the amortization of previously unrecognized unearned revenue.

Because unearned revenue is primarily recognized on Prime membership fees and AWS subscription fees, the reason for the decline must be from the slowdown of one of these two businesses.

Prime subscription revenue is included in "retail subscription services" net sales (along with other retail-related subscription services such as audiobook, e-book, digital video, digital music, etc.). AWS subscription revenue is included in AWS net sales along revenues from pay-as-you go method sales.

Based on results from Q1 and Q2, it can be seen that retail subscription services growth has accelerated, while AWS growth has stayed consistent. This observation suggests that it's unlikely that retail subscription was the cause of the decline in unearned revenue growth, so the decline in growth must have come from AWS.

The supposed decline in AWS is also consistent with the observations that Microsoft is rapidly gaining market share in the enterprise cloud market, in which large enterprises tend to use subscriptions, whereas small/medium enterprises tend to use the pay-as-you-go method. See our previous article for further evidences and support on the slowdown of AWS.

Ultimately, it's impossible to know the exact source of the decline in unearned revenue growth, because historical net sales is a lagging indicator of unearned revenue. So it is only from future financial reports that we are able to know the source of the decline of unearned revenue in Q2.

Regardless the source of the growth decline, it is extremely concerning that a high-growth company like Amazon would experience a sudden and drastic decline in unearned revenue. If Amazon's unearned revenue is an accurate proxy for future subscription sales, then it's reasonable to expect either Prime or AWS to slowdown meaningful in the near future.