2a. 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.
95 96 97 98 99
Total R&D costs 860 1326 1863 2601 2970
Capitalize 60% of 516 796 1118 1561 1782
current year and 258 398 559 780
remaining capitalized
amount of previous year
Capitalized R&D 1054 1516 2120 2562
(Increase in PPE)
Expense preceding two 258 398 780
years’ R&D 398 559 559
Expensed R&D 656 957 1339
Using current capitalization
policy, expense 60% anyway 1118 1561 1782
Increase in profit if
using new capitalization
policy 462 604 443
2b. Speculate as to why Microsoft chose to expense all software costs as incurred rather than capitalizing a portion of these costs?
Expensing these costs reduces the amount of reportable revenues/income/earnings etc., consequently reducing shareholders equity. This technique is typical of a company with such a conservative reporting method. Microsoft may have wanted to have the R&D listed as an expense now, while understanding the costs will generate revenues in the near future. Also, with their mysteriously pessimistic aura they could have conceived an idea the R&D costs may not be capable of producing any future revenues and in that case, the costs have already expensed.
3. What effect did Microsoft's revenue recognition policy have on its financial statements? Ignore any potential tax effects.
Microsoft's revenue recognition policy from Window's operating systems increased their liabilities by increasing unearned revenues by $425 in 1996 and $860 in 1997. Additionally, Microsoft's Revenue, Net Income and Total Stockholders' Equity were reduced on each of their respective statements.
3a. Estimate the amount of revenue that Microsoft would have reported each year from 1996 through 1999 if Microsoft had not adopted its new revenue recognition policy in 1996.
Reported Adjusted
Unearned revenue (L) Net increase 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%
3b. Speculate as to why Microsoft decided to defer a portion of its revenues in fiscal 1996.
Deferring portions of revenue allowed Microsoft to downplay their revenues, shelter the income from 1996 taxes and establish backup account which would be evenly distributed over the life cycle of the products. Doing this allowed Microsoft to effectively manage their reported income for the future and establish a conservative foundation for reporting earnings to Wall Street.
4. What was the overall impact of these two policies on Microsoft's fiscal 1997, 1998, and 1999 financial statements?
The impact of implementing both of these policies (software capitalization policy and their deferral revenue recognition policy) resulted in revenue being deferred on the financial statements ,which do not allow for Microsoft's true earning potential to be immediately recognized and may paint an unrealistic picture about the companies true financial status. One could argue the true value of the company can't be determined as a result of these two conservative policies.
The largest impact was upon the Statement of Cash Flows and on the Balance Sheet. To illustrate the impact of these two policies on the financial statements: In 1996, the annual average of unearned revenue balance was 20% of the annual average of total revenues, in 1997 it was 35%, in 1998 it was 58% and finally in 1999 the balance was 76% of quarterly revenues. At the end of Q4 in 1999, Microsoft's balance of unearned revenues was 73% of that quarter's earnings, which means Microsoft had 73% of an entire quarter's earnings in unearned revenues, which is astounding! Both of these conservative policies working together enabled this.
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?
In my opinion, yes, Microsoft did provide analysts' overly pessimistic information. High five's between the Mr. Gates and Mr. Ballmer after providing gloomy expectations at an analyst meeting might indicate some amount of premeditated pessimistic forecasting strategy. I also found the story about Bill Gates "incredibly conservative approach" to ensure he saved enough to pay for an entire year's payroll to be verification Microsoft in one way or another would have found a way to establish large balances in its current assets account.
If providing outwardly pessimistic earnings estimates helps allows a company to meet or exceed Wall Street's expectations 52 of 53 quarters since going public, then someone might suggest that is a benefit of their conservative/pessimistic strategy.
6. Describe Microsoft's overall financial reporting strategy. Why had the company adopted this strategy and why was the SEC concerned about it?
Overall, Microsoft had a conservative financial reporting strategy. The company adopted this strategy to regulate their earnings, provide for reserve funds and in order to meet Wall Street's expectations. Meanwhile, the potential for sudden changes in its industry was also one reason the company adopted this conservative financial reporting strategy.
The SEC was concerned about it because they are afraid Microsoft is not giving a faithful representation about what their true value is and what future earnings will be. Additionally, they are concerned Microsoft may be manipulating reserve accounts to smooth earnings and meet Wall Street's expectations.