*Microsoft’s Financial Reporting Strategy

1. What are the factors that likely explain the difference between Microsoft’s 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 company’s market value. Notice also that the
company’s choice of conservative accounting policies has the effect of depressing the company’s
book value of equity.

2. What effect did Microsoft’s software capitalization policy have on its financial statements?
Ignore any potential tax effects.
a. Assume that 60% of Microsoft’s 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 Microsoft’s fiscal 1997, 1998, and 1999
income statements and balance sheets.

1995 1996 1997 1998 1999

R&D recognized on the I/S 860 1,326 1,863 2,601 2,970

These are the adjustments to 516 258 0

capitalize 60% of the R&D expense 796 398 0
every year and to amortize it with 1,118 559 0
SL in 2 years 1,561 780
1,782
Capitalized Development Costs EB 516 1,054 1,516 2,120 2,562

Amortization expense 656 957 1,339

Development costs expensed (60% of R&D) 1,118 1,561 1,782

Reduction in profit b/c of expensing Develop. -462 -604 -443

As a % of reported profit before taxes -8.70% -8.50% -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.
Microsoft’s 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 company’s 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 Microsoft’s 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.
 Reported Adjusted
Unearned revenue (L) Change revenue revenue % increase
EB 1995 0
EB 1996 560 560 9,050 9,610 6.2%
EB 1997 1,418 858 11,936 12,794 7.2%
EB 1998 2,888 1,470 15,262 16,732 9.6%
EB 1999 4,239 1,351 19,747 21,098 6.8%

b. Why do you think Microsoft decided to defer a portion of its revenues in fiscal 1996?

The company’s decision to defer revenues came at a time of significant growth in revenues—
suggesting that the company’s decision to defer revenues was partially to dampen or “smooth”
the company’s revenue growth. The company’s 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 company’s history. While the
timing of the company’s 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 company’s current treatment
of software development costs, the company’s deferral of revenues exaggerates the mismatching
of expenses with revenues. Still, the company’s policy on revenue recognition is more
consistent with accrual accounting than is the company’s policy on software development
expenses.

4. Describe Microsoft’s overall financial reporting strategy in 1997-99. Why did the company
adopt this strategy and why was the SEC concerned about it?

1. Hiding profits—Microsoft’s phenomenal success may have provided them with an incentive to
hide their success from regulators and competitors. Given the company’s history with regulatory
intervention, there is likely a strong incentive for them to dampen their performance. However,
it should be noted that the company’s software capitalization policy occurred prior to any
serious regulatory intervention.
2. Signaling—By 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.
3. “Competitive weapon”—As an industry leader, Microsoft has the ability to influence the
accounting policies and practices that develop within the industry. In fact the AICPA’s
subsequent SOP on software revenue recognition arose out of Microsoft’s 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.
4. Avoiding 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 company’s 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
company’s 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.