*Microsofts Financial Reporting Strategy

1. What are the factors that likely explain the difference between Microsofts market value of equity and its reported book value of equity? The most obvious reason for the difference between the market value of equity and the book value of equity is the inability to record certain intangible assets such as brand value, customer loyalty, and perhaps most importantly, human capital. These intangible assets are likely to provide tremendous earnings growth in the future which determines the companys market value. Notice also that the companys choice of conservative accounting policies has the effect of depressing the companys book value of equity. 2. What effect did Microsofts software capitalization policy have on its financial statements? Ignore any potential tax effects. a. Assume that 60% of Microsofts research and development expenses were incurred after technological feasibility was established, that the average product life was two years, and that the company begins amortizing software costs at the beginning of the following year. Estimate the effect of capitalizing software costs on Microsofts fiscal 1997, 1998, and 1999 income statements and balance sheets.
R&D recognized on the I/S These are the adjustments to capitalize 60% of the R&D expense every year and to amortize it with SL in 2 years Capitalized Development Costs Amortization expense Development costs expensed (60% of R&D) Reduction in profit b/c of expensing Develop. As a % of reported profit before taxes
EB

1995 860 516

1996 1,326 258 796

1997 1,863 0 398 1,118

1998 2,601

1999 2,970

0 559 1,561 2,120 957 1,561 -604 -8.50%

516

1,054

1,516 656 1,118 -462 -8.70%

0 780 1,782 2,562 1,339 1,782 -443 -3.70%

b. Why do you think Microsoft chose to expense all software costs as incurred rather than capitalizing a portion of these costs? Remember that the FASB provides explicit guidelines for the treatment of software development costs that required capitalization once technological feasibility was established. Microsofts determination that the standard did not materially affect the Company likely rested on one of two lines of reasoning. First, the point at which the company determined the technological feasibility of their products may have been sufficiently late in the development process as to make the amount of software costs eligible for capitalization too small to have a material affect on the companys financial statements. Second, the company may have determined the useful life of the product to be so short-lived as to make expensing costs as incurred essentially equivalent to capitalization. 3. What effect did Microsofts revenue recognition policy have on its financial statements? Ignore any potential tax effects. a. Estimate the amount of revenue that Microsoft would have been reported in each year from 1996 through 1999 if Microsoft had not adopted its new revenue recognition policy in 1996.

Unearned revenue (L) EB 1995 0 EB 1996 560 EB 1997 1,418 EB 1998 2,888 EB 1999 4,239

Change 560 858 1,470 1,351

Reported revenue 9,050 11,936 15,262 19,747

Adjusted revenue 9,610 12,794 16,732 21,098

% increase 6.2% 7.2% 9.6% 6.8%

b. Why do you think Microsoft decided to defer a portion of its revenues in fiscal 1996? The companys decision to defer revenues came at a time of significant growth in revenues suggesting that the companys decision to defer revenues was partially to dampen or smooth the companys revenue growth. The companys decision to defer revenue had the effect of reducing reported revenue growth from 88% to 64% in the first quarter of 1996 and increasing revenue growth from 4% to 15% in the first quarter of 1997. Even as reported the first quarter of 1997 represented the lowest quarterly revenue growth in the companys history. While the timing of the companys decision to defer revenues appears particularly opportune, the introduction of Windows 95 to the market provides a legitimate reason for the decision. As described in the case, the company expected to integrate its Internet technologies into both Windows 95 and Office 97 at no additional cost to customers. Arguably, then, sales of these products were improved by these implicit promises and a portion of these revenues should be deferred into the future. However, to the extent the development costs of providing these enhancements have already been incurred and expensed under the companys current treatment of software development costs, the companys deferral of revenues exaggerates the mismatching of expenses with revenues. Still, the companys policy on revenue recognition is more consistent with accrual accounting than is the companys policy on software development expenses. 4. Describe Microsofts overall financial reporting strategy in 1997-99. Why did the company adopt this strategy and why was the SEC concerned about it? 1. Hiding profitsMicrosofts phenomenal success may have provided them with an incentive to hide their success from regulators and competitors. Given the companys history with regulatory intervention, there is likely a strong incentive for them to dampen their performance. However, it should be noted that the companys software capitalization policy occurred prior to any serious regulatory intervention. SignalingBy selecting conservative accounting policies and still reporting strong earnings numbers, Microsoft is able to signal their financial strength. In other words, they are able to demonstrate their ability to take the hit to earnings and still provide strong results. Competitive weaponAs an industry leader, Microsoft has the ability to influence the accounting policies and practices that develop within the industry. In fact the AICPAs subsequent SOP on software revenue recognition arose out of Microsofts original policy decision. As the strongest player in the industry, Microsoft can make it more difficult for other companies to show strong performance by setting norms that reduce earnings and assets. Avoiding complacencyThis argument is the subtlest of the four and suggests that the company dampens its earnings performance to avoid the potential for complacency that often accompanies financial success. The companys philosophy of fostering a sense of constructive paranoia about its competitive position and Gates policy on maintaining large cash balances are both consistent with this argument. The argument is perhaps a better explanation for the companys tendency to talk down analysts expectations rather than as an explanation for selecting conservative accounting policies, but the argument could certainly be made for both phenomena.

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