SQL Server Compatibility Level – Allowing Unsupported Functions

This is a bug in SQL Server 2012, and will be fixed in SP2:

http://connect.microsoft.com/SQLServer/feedback/details/779077/output-clause-fails-when-doing-update-using-cte

A workaround is to remove the + 1 from the ROW_NUMBER() calculation; this spurious error message goes away. Rewrite this portion:

  NewLineNumber = row_number() over 
    (partition by SalesOrderID order by SalesOrderDetailID)
    ---------------- remove the +1 here --------------------^^^
  from Sales.SalesOrderDetail
  where SalesOrderID <= 44000)
update sod 
  set LineNumber = NewLineNumber + 1,
  ------- and put it here -------^^^

After a considerable amount of testing, I finally discovered the reason behind this error. The client connection explicitly set ANSI_WARNINGS and CONCAT_NULL_YIELDS_NULL OFF. XML data operations, such as @data.value('(/EVENT_INSTANCE/EventType)[1]', 'nvarchar(100)'), require both to be ON. I had attempted to override these within the trigger, but I may have placed them wrong. The final code below works, even with the explicit SET options in the connections from Great Plains:

CREATE TRIGGER [ddl_log] 
ON ALL SERVER 
FOR DDL_DATABASE_LEVEL_EVENTS, DDL_SERVER_LEVEL_EVENTS 
AS
BEGIN
SET NOCOUNT ON;
SET ANSI_WARNINGS, CONCAT_NULL_YIELDS_NULL ON;

DECLARE @data XML
SET @data = EVENTDATA() 

EXECUTE AS LOGIN='<dummy login>'
INSERT admin.dbo.ddl_audit (PostTime, DB_User, [Event], [TSQL], Host, DatabaseName)
VALUES (
   GETDATE(),
   CONVERT(NVARCHAR(100), ORIGINAL_LOGIN()),
   @data.value('(/EVENT_INSTANCE/EventType)[1]', 'nvarchar(100)'), 
   @data.value('(/EVENT_INSTANCE/TSQLCommand)[1]', 'nvarchar(2000)'), 
   CONVERT(NVARCHAR(100), HOST_NAME()),
   @data.value('(/EVENT_INSTANCE/DatabaseName)[1]','nvarchar(100)')
   ) ;
REVERT 
END

As an alternative, I also could have simply inserted EVENTDATA() as an XML LOB into a table, rather than parsing it out into columns. Because I would not be manipulating the XML, the SET options do not matter. Then I would just build an XML index for querying performance, and construct a view to use for audit log reporting that parses the XML in the view definition, in the same manner as I am doing above in my INSERT statement.

Thanks to Max for pointing me in a different research direction, and @AaronBertrand on #sqlhelp who helped me with correct SET options within the body of the trigger.