Case ID: 100027     Solution ID: 37095     Words: 1699 Price $ 45

Microsofts Financial Reporting Strategy Case Solution

Abstract

Microsoft, for the most part, takes after Generally Accepted Accounting Principles as a strategy for announcing its monetary articulations and related notes. Rather than taking after the Generally Accepted Accounting Principles when all is said in done, Microsoft has embraced the Generally Accepted Accounting Principles which are particularly polished in the United States of America. The money related articulations distributed by Microsoft incorporate the outcomes for Microsoft Corporation and all different backups connected with the parent organization.


Moreover, Microsoft takes after money premise bookkeeping and gathering bookkeeping techniques, as well. The money premise bookkeeping strategy expresses that organizations ought to record costs and expenses in monetary explanations and related records just when the money has been really paid out. So also, Microsoft registers income and other monetary benefits just when the exchange has been finished, and the money is gotten.

Figure 1 - 1: Determinates of Stock Prices


Managerial Actions, The Economic Environment, and the Political Climate


"Perceived" Expected Future Cash Flows Figure 1 - 2: Determinates of Book Value of Equity


"Perceived" Risk


Assets - Liabilities = Stockholders Equity

Microsoft's Financial Reporting Strategy


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In comparing the exhibits below, we can see correlated earnings performance to the stock price which links positive earnings performance to the market value of equity. Exhibit 1-3 Microsoft Corp., Financial Performance since Initial Public Offering 20,000 18,000 16,000 14,000 12,000 $'s in millions 10,000 8,000 6,000 4,000 2,000 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Year Source: Microsoft Corp. Financial History Pivot Table, available at http://www.microsoft.com/msft/history.htm Revenue Operating Income Net Income


Exhibit 1-4 Microsoft Corp., Stock Performance since Initial Public Offering


Source: Microsoft Corp. Stock Price History Interactive Chart, available at http://investing.money.msn.com/investments/equity-charts


Microsoft's Financial Reporting Strategy Assessment of Revenue Recognition Policy:


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In 1996, Microsoft began to take a uniquely conservative revenue recognition approach on two selected product sales: Operating systems and Office 97. The company decided that given its strategy to integrate an internet browser, telephone support, technical support, and product enhancements into its products. Deferring revenue in the following manner: 20% of the revenue from

the sale of operating systems deferred over the two-year product's life cycle. 20% of the revenue from the sale of Office 97 deferred over the 18-month product life cycle. This revised recognition policy resulted in unearned revenue growing from $1.4 billion to $4.2 billion from 1997 to 1999 (Mausumoto & Bowen, 1999). Figure 2 - 1: Unearned Revenue balance at year-end from 1997 to 1999 ($'s in millions) Unearned revenue balance, in June. 30 Growth of unearned revenue (1997 base year) Year-over-year growth 1997 1,418 100% 1998 2,888 104% 204% 1999 4,239 199% 147%

Microsoft's Financial Reporting Strategy

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Entire inclusion of software costs in its R&D expenses misrepresents the economics of the company by understating asset, income, and equity. This was an aggressive stance because accounting guidance identifies these cash outlay have a degree of presumable future benefits. Assuming we capitalized all software development costs incurred in 1997, 1998, and 1999, Microsoft would have had a $216, $308, and $45 million dollar increase


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on the income statement and $707, 1,015, and $1,060 million increase on the balance sheet in 1997, 1998, and 1999 respectively (see appendix A for details). Figure 3- 1: "what-if" capitalization computation: impact on balance sheet & income statement from year 1997 to 1999


($'s in millions) Income statement impact increase or (decrease) Balance sheet impact increase or (decrease)


1997 216 707


1998 308 1,015


1999 45 1,060


What-if Scenario on Research & Development Cost: Had Microsoft elected to capitalize 60% of its R&D expenses, they would have realized additional operating income on the income statement by $462, $604, and $443 million with an additional increase on the balance sheet by $1.5, $2.1, and $2.5 

billion in 1997, 1998, and 1999 respectively Figure 4- 1: Microsoft's "what-if" capitalization computation: impact on income from year 1997 to 1999 Income Statement, with capitlization 1997 $ 11,936 745 5,202 656 6,603 $ 5,333 462 462 6.2% $ $ $ 1998 $ 15,262 1,040 6,247 957 8,244 7,018 604 1,066 6.8% 1999 $ 19,747 1,188 6,849 1,339 9,376 $ 10,371 $ $ 443 1,508 6.0%


Income Statement, as reported ($'s in millions) Revenue Operating expenses R&D expenses Operating expenses Amortization expense Total operating expenses Operating Income 1997 $ 11,936 1,863 5,202 0 7,065 $ 4,871 $ 1998 $ 15,262 2,601 6,247 0 8,848 6,414 $ 1999 $ 19,747 2,970 6,849 0 9,819 9,928


Difference from as reported: $ Cumulative difference: $ R&D % of Revenue 15.6% 17.0% 15.0%


(see appendix B for details)


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Figure 4- 1: Microsoft's "what-if" capitalization computation: impact on balance sheet from year 1997 to 1999 ($'s in millions) 1995 1996 1997 1998 1999 R&D expenses 860 1,326 $ 1,863 $ 2,601 $ 2,970 x 60% capitalization rate 60% 60% 60% 60% 60% Capitalization of Software Costs $ 516 $ 796 $ 1,118 $ 1,561 $ 1,782 Amortization expenses Software capitalization asset balance at 01/01 Plus: captalized amounts Less: amortization Software capitalization asset balance at 12/31 Balance sheet impact increase or (decrease) $ 258 516 $ 796 (258) $ 1,054 $ $ 656 1,054 $ 1,118 (656) 1,516 $ 1,516 $ 957 1,339


$ 516


1,516 $ 2,120 1,561 1,782 (957) (1,339) 2,120 $ 2,562 2,120 $ 2,562

Microsoft's Choice to Expense Software Development Costs: Why did Microsoft choose to take such a conservative approach when dealing with software development costs? Microsoft's Pessimistic Outlook : Microsoft was also known to be overly pessimistic in its earnings outlook with analyst. This approach benefited the firm by some degree as analysts were known to anchor earnings expectations to management outlook. If analyst bought the pitch, this meant lower than realistic expected earnings numbers thus making it easier for Microsoft to meet expectation. One analyst made this comment about the firm, "a lot of companies lowball estimates. Microsoft has been doing that for a long time. The fact that Microsoft was able to meet or exceed analysts' expectations in 52 of 53 quarters since going public was at least partially attributable to the conservative guidance Microsoft executives provided to the financial analyst community" (Mausumoto & Bowen, 1999).


Microsoft's Financial Reporting Strategy Assessment of Microsoft's Overall Reporting Strategy:


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Microsoft's overall financial reporting strategy was aimed at manipulating earnings and revenues to maintain artificial steady profits and revenue growth. The company diminished results in the present and set aside reserves with the effect of reducing revenue and reversing it in later periods which is better known as the "cookie-jar" approach. Many agree the firm did this in the hopes of smoothing perceived growth to please investors and analysts in the wake of a slumping industry (Mausumoto & Bowen 1999). 

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Questions Covered

1. What accounting methods does Microsoft select?

2. What is Microsoft's financial reporting strategy regarding the accounting issues of (A) software capitalization and (B) revenue recognition?

3. Discuss reasons for Microsoft’s accounting and disclosure choices?

4. What issues can arise from Microsoft’s financial reporting regarding managing?