"Microsoft's Financial Reporting Strategy"

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Case Study 1

“Microsoft's Financial Reporting Strategy

Harvard case number 9-100-027, Professors Dawn Matsumoto and Robert Bowen


  1. Difference between Market and Book value of equity

From Exhibit 1 (Financial performance since initial public offering) in the article, it can be inferred that Microsoft achieved consistently increasing growth in revenues from $140M to around $20B and net income from $24M to around $8B, from years 1985 to1999. This tremendous growth may be one of the reasons for the difference in market value and book value of its equity.

Next, it can be seen from the company’s financial statements that the ratio of the current assets to the non-current assets has always been greater than 1, implying a good liquidity of the firm. More specifically, the ratio of around 1.2 indicates that a major portion of its assets is liquid. This might also be a reason for investors’ valuation of the share at $85 compared to its original value of $25, thus contributing to the difference in equities.

Third, for the year 1999, the market value of each share was around $85, which grew from around $25 in 1986. But the book value of equity is based on the amount of money raised from issuing stocks over the period from 1986 to 1999. This is a likely cause for the difference between the two equities.

Also, in general, ROCE is a measure of the rate that common shareholders are earning on their shares. Companies that generate high returns relative to their shareholder's equity are companies that create substantial assets for each dollar invested. These businesses are more than likely self-funding companies that require no additional debt or equity investments. A look at the ROCE for Microsoft over the period, (6.Appendix), suggests that the company is highly capable of generating profits. Another indicator of ability of producing high profit margins is the Asset Turnover. This ratio has been consistently low (and fell from 0.82 in 1997 to 0.53 in 1999) over the three-year period ending 1999. Further, from the company’s website the measures of reported Earnings Per Share (EPS) is as follows, which has grown tremendously in 1999:

All these might have invited more investors and also help the market value of the stock in 1999 to rocket to more than three times of its initial value in1985.


  1. Effects of Software Capitalization

By writing down research and development costs as expenses as and when they occur, instead of following SFAS No. 86, Microsoft attempted not to capitalize/convert the expenses incurred after the technological feasibility point.

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Effects of this:

  • Increase in expenses due to R&D and hence decrease in Net income on their Income statement
  • If capitalized, the capitalized amount will be conceived or realized as an asset on Balance sheet. Hence, on Balance sheet, Microsoft’s assets were of lower worth.
  1. Effect on financial statements

  1. Income statement

WorkSheet 1: Microsoft's Revised Income Statement with capitalized R&D expenses

From the revised Income statement (WorkSheet 1), it can be seen that if 60% of the R&D expenses are capitalized and amortized for next 2 years then the Net income will increase by $1117.8 ...

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