MICROSOFT’S

FINANCIAL
REPORTING
STRATEGY

FINANCIAL REPORTING & ANALYSIS

ASHISH (318) | KESHAV (332)

KRITIKA (333) | PAYAL (342)
POOJA (344) | RAHUL (351)
 Microsoft’s Financial Reporting Strategy
1. Explain the reasons for difference between book value of equity and market value of equity
of Microsoft?

Ans 1: Difference between book value of equity and market value of equity of Microsoft can be
attributed to following reasons:

a. Conservative Accounting Policies: Microsoft is using conservative accounting policies which

results in decreasing the book value of equity for the company.
b. Inability to record Intangible Assets: A company’s future growth prospects determine its
market value. Given the tremendous growth trend of Microsoft, its market value is expected
to be high. The company does not record intangible assets which contribute significantly in
the IT industry. These intangible assets like employees of the company, brand value,
copyrights and patents, etc. should be important in determining the market value of the
company.

2. What effect did Microsoft’s software capitalization policy have on its financial statements?
Ignore any potential tax effects.

Ans 2: The company’s R&D costs are expensed as incurred and they do not capitalize on these
costs. As per FASB rules and guidelines, capitalization could be done after technological feasibility
or once the design is complete or useful life of the product. Microsoft did not capitalize and
probably there could be one of the two reasons:

1995 1996 1997 1998 1999

R&D Costs from IS 860 1326 1863 2601 2970
Adjustments for amortization, assuming 50% 430 215 0
capitalization of R&D expense, and SLM
663 331.5 0
amortization in 2 years
931.5 465.75 0
1300.5 650.25

Capitalized costs 430 448 600 834.75 2319.75

Amortization expense 546.5 797.25 1116

Development Costs expensed at 50% 931.5 1300.5 1485

Total R&D cost attributed 1478 2097.75 2601

Reported R&D Expense 1863 2601 2970

Over-Reported Expense 385 503.25 369
Reported Operated Profit 4871 6414 9928
Actual Operated Profit 5256 6917.25 10297
Profit % Increase 7.90% 7.85% 3.72%
 a. When Microsoft achieved technological feasibility, they may have been late in the
development process to be able to realize much value from capitalization, thus not having
much effect on the financial statements.
b. Useful life determined of the developed products might be short.

But following this policy would have adverse impact on the income of the company.

To illustrate the same during the last five years, we’ll assume that:

i. 50% of Microsoft’s R&D expenses incurred after technological feasibility was

established
ii. Average product life of the product is assumed to be two years
iii. Amortization using straight line method from the following year

3. What effect did Microsoft’s revenue recognition policy have on its financial statements?
Ignore any potential tax effects.

Ans 3: Microsoft followed a conservative financial strategy for revenue recognition which
ultimately increased its market value in terms of brand value, customer loyalty and human
capital. Although the company was operating in a volatile industry, it always showed a consistent
financial growth. Its revenue grew at an average rate of 43% per year (from the year 1986) and
operating income grew at an average rate of 49% per year (from the year 1986).

1997 1998 1999

Revenue(mn) 11936 15262 19747
Operating Income(mn) 4871 6414 9928
Unearned 858 1470 1351
Revenue(mn) for this
year
Actual Revenue(mn) 12794 16732 21098
% increase in 7.18% 9.63% 6.85%
Unearned revenue

Microsoft followed an 80/20 deferred revenue policy for software arrangements consisting of
upgrades or other enhancements. This helped the company to smooth revenue growth using
“Cookie Jars” strategy and balance in unearned revenue increased steadily that by the end of
1999 it was 4.2 billion (equivalent to a quarters revenue).

4. What was the overall impact of these two policies on Microsoft’s fiscal 1997, 1998, and 1999
financial statements?

Ans 4: On an overall basis the software capitalization policy of Microsoft during 1997, 1998, 1999,
was to expense all the costs which caused a decrease in income before tax accounted for research
and development costs of 1863milllion, 2601 million, and 2970 million for respective years. If the
company followed GAAP policies then these costs should have been capitalized but they expensed
 it to reduce the reporting profit and income. If the company must have written these costs in the
balance sheet then they would have been amortized hence the retained profit would increase in
the balance sheet.

The company’s conservative revenue recognition policy did not recognize unearned revenue in
earnings based on different software arrangements for upgrades and enhancements ultimately
deferring revenue for revenue smoothening and increasing liabilities by 1418 million, 2888
million, and 4239 million in 1997, 1998, and 1999 respectively.

The overall change in income was 25.52% in 1997, 20.76% in 1998, 17.32% in 1999 as they were
under reporting their profits.

Year 1997 1998 1999

Reported Revenues 11936 15262 19747
Unearned Revenues 858 1470 1351
Actual Revenues 12794 16732 21098
Reported Operating Expenses 7065 8848 9819
Over Reported R&D Expenses 385 503 369
Actual Operating Expenses 6680 8345 9450
Reported Operating Income 4871 6414 9928
Actual Operating Income 6114 8387 11648
% Change in Income 25.52% 30.76% 17.32%

5. In your opinion, did Microsoft provide its analysts with information that was intentionally
overly pessimistic? Are there any benefits to the company to being outwardly pessimistic
about its future prospects?

Ans 5: Yes, in our opinion the pessimistic outlook was intentional on the part of Microsoft. As given
in the case, company was able to beat the analyst views 52 out of 53 quarters and being branded as
giving the pessimistic outlook as the norm for the company indicates the voluntary approach.

The company did gain benefits through these practices. We can divide the benefits in two parts, the
market benefits and the corporate culture benefits:

• Market benefits: By showing pessimistic guidance, it was natural for the analysts to forecast
pessimistic results for the company. This gives company a breather in the sense that if it was
able to live up to the previous performances, they would benefit from beating the market
expectations and instilling the investors’ confidence boosting the share prices post results
declaration on the other side, it gave company an arm’s length from living up to the
previous performances and if they are not able to meet the performance, no negative
surprises would be there on the part of the company and investors would have successfully
hedged against the possible upcoming loss due to pessimistic guidance hence making
stakeholders prepare for the worst beforehand.
• Corporate Culture benefits: With giving out pessimistic outlook, the employees and
managers had to perform better to avoid making the outlook true. This helped them remove
complacency in the firm by not recording excessive profits and employees have to maintain
the competitive spirit. The practice of looking over the shoulder every time helped Microsoft
keep their feet on the ground. Further, with conservatism practices like maintaining cash
balance equivalent to one year’s expenses was a pure hedging technique keeping the firm
safe.
6. Describe Microsoft’s overall financial reporting strategy. Why did the company adopt this
strategy and why was the SEC concerned about it?

Ans 6: Microsoft kept a conservative approach of financial reporting which troubled the SEC due
to being sheer advantage earned by treading in the grey area of loopholes. Company used
deferred revenue approach for recording the revenues. They used 80/20 rule, 80% of the
revenues were reported whereas the 20% were reserved. Further, they didn’t capitalise their
R&D cost leading to decrease in the profits.

The SEC was concerned of the following:

• Cookie Jar Revenue: By keeping 20% as unearned, Microsoft was able to build a “Cookie
Jar” equivalent to their quarterly revenues by 1999. This is problematic as company can
use these unearned revenues to smooth their income over the year to hide the any
downfall during the year by just recognising the unearned revenues. As per SEC this was
unethical on the part of the company.
• Signalling: By giving out pessimistic outlook and then beating the analysts’ estimations,
company gained a lot in the stock market. They were signalling the financial strength of
the company that it is able to get higher results even after the pessimistic guidance. This
was also unethical on the part of company which was using the conservative approach
to boost their stock prices and misled the analysts.
• Dominant Position: With Microsoft as industry leader, it was in the dominant position to
shape the industry practices. This can be used as competitive weapon to keep the
competition below by using their strong financials and pessimistic approach to reporting
leading to smaller companies not able to cope up.

All of these give substantial reasons to SEC to limit the Microsoft’s grey treading approach to
benefit the company most keep the dominant position in the market.