PAKISTAN WATER AND POWER DEVELOPMENT AUTHORITY

Microsoft’s Financial Reporting Strategy

Case Study Analysis Report

Submitted by: Mubashar Ali Jamro

Assistant Manager (Accounts & Finance)
WAPDA Hospital Hyderabad

155th JMC, WAPDA Administrative Staff College Islamabad

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TABLE OF CONTENTS

Executive Summary 2

Introduction 3

Problem Statement 4

1. Conservative Accounting Policy 4

1.a Software Development Cost 5

1.b Revenue Recognition 5

2. Revised Revenue Recognition Policy 6

3. Conservative Future Expectation/Managing expectation 6

4. SEC investigation 7

Overall Analysis of the Case 8

Recommendations 9
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Executive Summary

Microsoft Corporation is best known for the computer operating software and suite of products designed
for business professionals and home users alike. In the community of financial analysts Microsoft is
also known for its conservative accounting practices and consistent achievement of financial targets.
With any accounting principle there is always room for interpretation and subjective decisions which
can place a company under scrutiny if these decisions are unpopular with investors or seen as
misrepresenting the financial picture of the company. Microsoft’s conservative accounting principles,
management of analyst/stockholder expectations, and consistent achievement of financial targets
ultimately led the SEC investigation into their accounting practices.
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Introduction
The Microsoft is the developer and manufacturer of products such as the Windows Operating System
and Internet web Explorer. Over the years, it has become one of the leading software developers of the
world. The company was founded in 1975 with the view that a day would come when there would be
one computer on every desk and in every home. The company got a breakthrough when it signed an
agreement with IBM to provide the operating system for its personal computers. By the 1980s’, the
company had dominated the market for the operating system. The company became a public limited
company in 1986 at $25.75 which increase in the value of $13000 in 1999. In the same year, the
company had the highest market value in the United States of America and Bill Gates became the
world’s wealthiest individual.

However, the company has been facing investigation by the Securities Exchange Commission, Federal
Trade Commission, and the Department of Justice since 1990s. The charge levied included that the
company has been regularly involved in manipulating the reserves to smooth its earnings to show the
favorable position to their shareholders, auditors, and analysts. They have also been accused of the
policy of cooking the jar where the accruals are put into the jar in good times and then release them in
the future.

There are many accounting policies followed by the company. The main aim behind the policies is to
follow a conservative approach considering the competitiveness of the industry, the threats to be
encountered in the future, and the salary commitments to be fulfilled. However, the management does
not intend to follow any practice which does not comply with the US General Accepted Accounting
Principles (GAAP) and use the flexibility provided by the standards regarding the accounting treatment
of Software Capitalization and the recognition of revenue. The financial statements are prepared on a
consistent basis with U.S Generally Accepted Accounting Principles.

Problem Statement
Microsoft Corporations was under investigation by the Securities and Exchange Commission (SEC) for
its accounting practices. The investigation was believed to involve the company’s deferral of revenue
and other undisclosed reserve accounts.
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These issues were elaborated as:

1. The company was known to be relatively conservative in its accounting choices. GAAP allowed
flexibility in two areas for software developers, one in software development costs and two in
revenue recognition. Microsoft chose a rather conservative method of reporting in both these
areas.
2. After the release of Windows 95, company adjusted its revenue recognition policy due to change
in the commitments of sale of some software. This led to increase in the unearned revenue in
1997.
3. A conservative approach in discussing future expectations.
4. Suit filed against Microsoft that the company manipulated reserve accounts to smooth reported
earnings which prompted SEC investigation.

1. Conservative Accounting Policy

Microsoft follows a conservative accounting approach of expensing all research and development
(R&D) costs for software in the year the money is spent based on the FASB definition of technological
feasibility; this approach typically results in lower current year income. Microsoft may have determined
that technological feasibility could not definitively be established until late in the product development
life cycle which would justify expensing the majority of these R&D expenses. It is also likely that
Microsoft analyzed the impact of expensing versus capitalizing varying portions of these expenses and
determined that the impact of their decision to expense the costs instead of capitalizing was not material.
Similarily, Microsoft has a very conservative financial reporting strategy that does not recognize
revenue early or underestimate its liabilities. This culture of reservation and precaution can be seen
throughout the company and has integrated into their financial statements. They take care not to account
for transactions in ways that would temporarily, or artificially, inflate earnings or negate liabilities.
Revenue recognition is delayed past the sale because Microsoft knows that they will still be providing
additional support to the software. Estimates of liabilities are inflated to account for the possibilities of
negative outcomes instead of estimated for the most probable outcome. Accounting in this way reduces
the recognizable income by the company, but also reduces the risk that the company sees from
operations.

1.a Software Development Cost

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 non-feasible material does not effect to company. They also determine the
technological feasibility of their product may have been sufficiently late in the development process.
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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
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.
There are two reasons why accounting rules treat R&D outlays as expenses:
i. 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.

1.b Revenue Recognition

Microsoft also use consevative approach to record revenues. Instead of booking revenues when sale of
software occurs, instead Microsoft wait for the products to be shipped or installed by end-users before
recogniting the revenue. Prior to 1996, Microsoft would recognize the revenue as soon as they would
sell the product in case of sales to distributors and resellers, revenue were recognized when product was
shipped, revenues from corporate license programs were recognized when the users installed the
product, and revenues from products sold to OEMs (original equipment manufacturers) were recognized
when the OEM shipped the licensed products. Even though this is more in line with matching principle
of accounting but putting more stringent condition for revenue recognition provide leverage to Microsoft
to withheld some of its revenues.

2. Revised Revenue Recognition Policy

Microsoft revised a revenue recognition policy for their software revenues that allocates 80% of
revenues generated and the other 20% of revenues is amortized over the 2-year expected useful life for
its products. Thus, 1/24 of the 20% deferred revenue is to be recognized on a monthly basis for the 2-
year period following the initial sale. Microsoft's rationalization to this approach was that they provided
after purchase services to customers such as Internet-based technical support, telephone support, and
unspecified product enhancements and it is therefore allowable to recognize 20% of revenue over that 2-
year period.
Microsoft chose to recognize revenue in such a conservative manner in the hopes that the deferred
revenue of 20% from software sales can be amortized over a 2-year period and provide steady income
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growth for every quarter. In other words, Microsoft sought to "smooth" their income so that quarters
with high revenue would not be extremely large increases and so that some of those revenues could
benefit lowering performing quarters. By amortizing the 20%. Microsoft is able to apply a portion of
that amount of revenues to slower quarters and years and maintain a steady increase of income over
time.

3. Conservative Future Expectation/Managing expectation

Microsoft always kept an eye over its shoulder and a culture of pessimism in regard to its realized and
future cash flows was standard operating procedure. Management did not want to intentionally mislead
analysts into expecting poor performance from the coming year; they simply stated their outlook based
on the corporate culture. The entire business runs on a culture that is resistant to wishful thinking and
focuses on planning for the negative events that could impact the company.
There has been speculation that Microsoft has been artificially pessimistic about future events in
an effort to boost the perception of their performance. By understating future expectations, they are able
to more easily meet, or exceed, the goals that are established for the coming year. Exceeding the
estimates will usually cause a positive reaction from the market, showing that the company is doing
better than expected. However, in Microsoft’s case, they consistently provided estimates that are
inclusive of worst-case scenarios and conservative estimates. This has changed how analysts view
Microsoft’s estimates, taking them with a grain of salt and expecting more.

4. SEC investigation

The SEC’s investigation of Microsoft was reportedly prompted by a wrongful dismissal suit filed by the
company’s former head of internal auditing, Charles Pancerzewski.”
The suit, filed in 1997, charged that the company regularly manipulated reserve accounts to smooth
reported earnings and that the auditor was dismissed after questioning the practice to the CFO (in 1997),
Mike Brown. The suit was settled out of court in Fall 1998; the terms of the settlement were not
disclosed by mutual agreement.
The SEC began its investigation into Microsoft as a result of the practices Microsoft was using in its
accounting methods. The SEC interpreted some of the methods as deceptive instead of reserved. The
methods used by Microsoft to reduce risk, by delaying revenue recognition and overestimating
liabilities, could be used to smooth earnings. Good years were being downplayed, while years of poor
performance could be boosted by the accounting reserves. The SEC felt Microsoft’s success provided
the company with an incentive to hide their success from regulators as well as their competitors.
Another cause for alarm was that by Microsoft selecting conservative accounting techniques and still
able to report strong earnings numbers, signaling that they had the ability to provide their shareholders
financial strength even in tougher times.
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Overall Analysis of the Case

Following is the Microsoft’s overall financial reporting strategy:
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 performane. 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 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.
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Recommendations
Microsoft adopted these policies for several reasons, but by doing so, it caused concern from the SEC.
One reason for this concern was that the SEC felt Microsoft was hiding their profits. The SEC felt
Microsoft’s success provided the company with an incentive to hide their success from regulators as
well as their competitors. Another cause for alarm was that by Microsoft selecting conservative
accounting techniques and still able to report strong earnings numbers, signaling that they had the ability
to provide their shareholders financial strength even in tougher times. Since Microsoft (and is) an
industry leader, they are able to influence the accounting policies and practices throughout the industry,
which made it difficult for other companies to show that they are strong performers when their norms
involve reducing earnings and assets at times.

Following are few recommendations in light above discussion.

 Microsoft should follow the “technical feasiblity” rule for reporting its R&D expenditure and SFAS
No.-86 and IAS-38
 Microsoft should change their model for deferring revenues. The percentage of revenue deferred
should be decreased for both operating systems (e.g., Windows NT) and for desktop applications
(e.g., Office), the effect of which will be to increase reported revenue.
 The estimated product life cycle for operating systems should be extended.
 Microsoft should be realistic while providing the information to stakeholders. It will increase the
transparancy of company and build trust in company management.
 Keeping huge amount of cash for the sake of payroll payment and other cookie jar reserves should
be avoided and should be maintained with sufficient documentation of the bases for these reserve
accounts.