*Microsofts Financial Reporting Strategy

1. What are the factors that likely explain the difference between Microsofts market al!e of e"!ity and its reported book al!e of e"!ity# 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. $. What effect did Microsofts software capitali%ation policy ha e on its financial statements# &gnore any potential tax effects. a. 'ss!me that ()* of Microsofts research and de elopment expenses were inc!rred after technological feasibility was established+ that the a erage prod!ct life was two years+ and that the company begins amorti%ing software costs at the beginning of the following year. ,stimate the effect of capitali%ing software costs on Microsofts fiscal 1--.+ 1--/+ and 1--income statements and balance sheets.
R&D recognized on the I/S These are the adj st!ents to ca#ita$ize 60% o& the R&D e'#ense e(er) )ear and to a!ortize it *ith S+ in 2 )ears Capitalized Development Costs Amortization expense De(e$o#!ent costs e'#ensed -60% o& R&D. Red ction in #ro&it //c o& e'#ensing De(e$o#0 2s a % o& re#orted #ro&it /e&ore ta'es
EB

1995 860 "16

1996 1,326 2"8 796

1997 1,863 0 398 1,118

1998 2,601

1999 2,970

0 ""9 1,"61 2,120 957 1,"61 160, 180"0%

"16

1,0",

1,516 656 1,118 1,62 18070%

0 780 1,782 2,562 1,339 1,782 1,,3 13070%

b. Why do yo! think Microsoft chose to expense all software costs as inc!rred rather than capitali%ing a portion of these costs# Remember that the F !" provides e#plicit guidelines for the treatment of software development costs that required capitali$ation once technological feasibility was established. %icrosofts determination that the standard did not &materially affect the 'ompany( likely rested on one of two lines of reasoning. First, the point at which the company determined the technological feasibility of their products may have been sufficiently late in the development process as to make the amount of software costs eligible for capitali$ation too small to have a material affect on the companys financial statements. !econd, the company may have determined the useful life of the product to be so short)lived as to make e#pensing costs as incurred essentially equivalent to capitali$ation. 0. What effect did Microsofts re en!e recognition policy ha e on its financial statements# &gnore any potential tax effects. a. ,stimate the amo!nt of re en!e that Microsoft wo!ld ha e been reported in each year from 1--( thro!gh 1--- if Microsoft had not adopted its new re en!e recognition policy in 1--(.

3nearned re(en e -+. 56 199" 0 56 1996 "60 56 1997 1,,18 56 1998 2,888 56 1999 ,,239

4hange "60 8"8 1,,70 1,3"1

Re#orted re(en e 9,0"0 11,936 1",262 19,7,7

2dj sted re(en e 9,610 12,79, 16,732 21,098

% increase 602% 702% 906% 608%

b. Why do yo! think Microsoft decided to defer a portion of its re en!es in fiscal 1--(# 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 ++, to -., in the first quarter of /00- and increasing revenue growth from ., to /1, in the first quarter of /002. 3ven as reported the first quarter of /002 represented the lowest quarterly revenue growth in the companys history. 4hile the timing of the companys decision to defer revenues appears particularly opportune, the introduction of 4indows 01 to the market provides a legitimate reason for the decision. s described in the case, the company e#pected to integrate its 5nternet technologies into both 4indows 01 and 6ffice 02 &at no additional cost to customers.( rguably, then, sales of these products were improved by these implicit promises and a portion of these revenues should be deferred into the future. 7owever, to the e#tent the development costs of providing these enhancements have already been incurred and e#pensed under the companys current treatment of software development costs, the companys deferral of revenues e#aggerates the mismatching of e#penses with revenues. !till, the companys policy on revenue recognition is more consistent with accrual accounting than is the companys policy on software development e#penses. 1. 2escribe Microsofts o erall financial reporting strategy in 1--.3--. Why did the company adopt this strategy and why was the S,4 concerned abo!t it# /. 7iding profits*%icrosofts phenomenal success may have provided them with an incentive to hide their success from regulators and competitors. 8iven the companys history with regulatory intervention, there is likely a strong incentive for them to dampen their performance. 7owever, it should be noted that the companys software capitali$ation policy occurred prior to any serious regulatory intervention. !ignaling*"y selecting conservative accounting policies and still reporting strong earnings numbers, %icrosoft is able to signal their financial strength. 5n other words, they are able to demonstrate their ability to take the &hit( to earnings and still provide strong results. &'ompetitive weapon(* s an industry leader, %icrosoft has the ability to influence the accounting policies and practices that develop within the industry. 5n fact the 5'; s subsequent !6; on software revenue recognition arose out of %icrosofts original policy decision. s the strongest player in the industry, %icrosoft can make it more difficult for other companies to show strong performance by setting norms that reduce earnings and assets. voiding complacency*This 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 8ates policy on maintaining large cash balances are both consistent with this argument. The argument is perhaps a better e#planation for the companys tendency to &talk down( analysts e#pectations rather than as an e#planation for selecting conservative accounting policies, but the argument could certainly be made for both phenomena.

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