Microsoft Financial Reporting Strategy

1. What are the motifs of Microsoft treated the amount that they spend in R&D as part
of the expenses.
Microsoft expense all costs until it has completed the activities of development
process which is planning, designing, coding and testing. This is necessary for them to
establish standard that it can produce the products to meet its design specification.
There are guideline provided by FASB on treatment of R&D cost require capitalization
once technological feasibility established. Microsoft determines the standard on nonfeasible material does not effect to company. They also determine the technological
feasibility of their product may have been sufficiently late in the development
process. Secondly, the useful life of the product to be shortened as to make
expensing costs as incurred essentially equivalent to capitalization.
Allowing a company to capitalize rather than expense its R&D costs opens the door
for a manipulation of earnings. For instance, a company capitalizing a large R&D
charge shows better earnings results than a company that does not capitalize.
Furthermore, capitalization of R&D expenses events out earnings, an unrealistic
assumption because management does not know if its current capital outlays will
lead to a future benefit to earnings.
Like marketing expenses, but unlike capital expenditures, R&D expenses are
subtracted from revenues every year directly. Therefore, accountants treat R&D
spending as an expense rather than as an investment, though there is continuous
debate over whether this is the correct classification. An investor looking at
companies with large R&D expenditures should think hard about whether a single
company's R&D spending is an expense or whether it is an investment.
There are two reasons why accounting rules treat R&D outlays as expenses:
i.
First it is a cruel fact of life that not all R&D outlays lead to the development of
marketable products. In fact a relatively low percentage of such outlays lead to
successful products.
ii.
A second problem in treating R&D costs as assets involves deciding their useful
life. Assuming that successful R&D costs can be identified, over what period of
time do we spread or amortize these costs? If the R&D costs lead to a patent we
could simply use the life of a patent as our guide. But what really matters is the
life cycle of a successful new product, not the period of patent enforceability.

2. What happen if Microsoft treated that amount as part of their total asset? Discuss.

When we treat R&D expenses as capital expenditures, we have to maintain

consistency and treat cumulated R&D expenses as an asset. The simplest way to do
this is to cumulate the after-tax research and development expenses over time and
create a research asset. This asset will then be amortized over time, with both the
length of the amortization period and the amortization schedule being determined by
the nature of the research expenses, and the estimated time until there is a payoff to
the investment. Thus, for pharmaceutical companies where FDA approval can take as
long as a decade, the research asset will be amortized over an extended period. In
contrast, for high technology firms where the payoff is much sooner, the research
asset will have to be amortized over a shorter period.
For Microsofts case, let say we 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

1995
860

1996
1,326

Adjust to 60% of the

R&D expense every year
and to amortize it with
SL in 2 years
(A X 60%)

516

258
796

Capitalized
Development Costs
(Total B)

Amortization Expense

1,054

0
398
1,118

1998
2,601

0
559
1,561

1999
2,970

0
780
1,782

1,516

2,120

2,562

656

957

1,339

Development Cost
expensed (60% R&D)

1,118

1,561

1,782

Reduction in profit B/C

of expensing Develop.
(D-B)

-462

-604

-443

-8.70%

-8.50%

-3.70%

As a % of reported
profit before taxes

516

YEAR
1997
1,863

If accounting rules allowed the treatment of R&D costs as assets, management would
be sorely tempted to record both unsuccessful and successful outlays as assets. This
would lead to the overstatement of assets, the understatement of expenses and in
turn the overstatement of income. Even if management were neutral and fair minded
it is often impossible to predict which R&D costs will lead to successful products and
which will not. Determining the answer to that question can have a large impact on
how the company is valued.
Capitalization allows a company to spread the cost of an asset into future periods.
For example, depreciation allows a company to spread the cost of its tangible assets
over an estimated useful life. In contrast, R&D is an expense that may or may not
lead to an asset. For example, a chemical company may spend a significant amount of
R&D and expect it to generate $1 billion in sales over. However, if the product
produced does not meet standard approval, it will never come to market.