Source: Bessemer Venture Partners

Oracle’s (ORCL) revenues haven’t exactly been on a tear that last few years. I discuss the three main causes behind the softness in a video posted on the IOI Tools site. One of these is–contrary to what people might think to be common sense–its success in the field of Cloud Computing.

This counter-intuitive result is due to a difference in the way “revenue recognition” works for different types of software sales.

Oracle has historically sold software licenses outright. An organization owned the software from the moment the sales contract was officially signed and was the legal owner of that software in perpetuity. This meant that as soon as a sale was made and the software delivered, Oracle was able to report that sale as “complete” and count the entire amount of the check as revenue during that fiscal year.

However, Cloud software is not owned by the company using it, but rather “leased” over time–once the contractual period is up, the user abandons access to the program package. Companies selling software on this model often offer discounts to clients willing to commit to multi-year contracts. The company receives the buyer’s check up front, but in return, commits to providing service over the entire contractual period.

Anyone who pays for newspaper subscriptions understands this model. Get a discount for a yearly contract, pay for the subscription, then receive service for the next 12 months.

While straight-forward from an economic perspective, accounting for these transactions can be tricky because of something termed “revenue recognition“. For revenues to be recognized (i.e., included in a company’s accounts for a given time period), two things must hold true:

  1. Revenues must be earned–in other words, goods or services must be fully rendered to clients (e.g., the good must be delivered or the service completely performed).
  2. Revenues must be realized–in other words, the client has to pay the seller or the seller has to be confident of getting paid within a short time.

For newspapers and Cloud software, the company selling gets to realize some revenue (i.e., the client pays), before the revenues are completely earned (i.e., the subscription still has time before expiration).

To give a simple example, let’s say that ABC, Inc. bought a 5-year subscription to an Oracle Cloud product for $100. ABC writes the check to Oracle at the beginning of the year; at the end of the year, Oracle will report that it had ($100 / 5=) $20 in revenues from ABC.

In reality, these contracts get much more complex because different parts of the contractual package may have different subscription lengths, some parts of the package may include purchased software, etc., but this example gives the gist of what’s going on from an accounting perspective.

As Oracle has increasingly begun offering Cloud software, services, and infrastructure, a larger proportion of its revenues have had to be recognized over time or “ratably” in the parlance of the bean counters. This increase in ratable revenue has actually provide somewhere around a one percentage point headwind to Oracle’s top line growth and was the leading factor in Oracle missing analyst estimates for full-year FY14 revenue.

Ratable revenues can cause problems for analysts trying to understand a business. Value investors love to hate Oracle’s big Cloud competitor, (CRM) because of Salesforce’s “low profit margins.” However, as I explain in these Valuation Notes for the IOI Tear Sheet on, the company’s profitability is affected by issues of revenue recognition. Looking at accounting earnings might lead an analyst to believe the company is not profitable, but looking at IOI’s preferred measure of earnings–Owners’ Cash Profits–explained in detail in The Framework Investing, Salesforce’s profitability doesn’t look half bad, especially for a young, quickly growing firm.