Microsoft financial reporting strategy

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1.       What are the factors that likely explain the difference between Microsoft's market value of equity and its reported book value of equity?

Microsoft's market value of equity is notably different from its reported book value of equity for two aspects of reasons.  

First of all, Microsoft’s software capitalization policy and revenue recognition policy make it have a lower reported book value of equity. Microsoft expensed all incurred research and development costs in which some should have been capitalized. This accounting treatment resulted in lower earnings, lower retained earnings and lower book value of equity. Meanwhile, in 1996 Microsoft began recognizing 20% of revenues from Windows operating systems over the products life-cycle rather than recognizing it at the point of sale. This helped provide a 298% increase in unearned revenue but lowered revenue between 1997 and 1999. This accounting treatment resulted in the same effect to the reported book value of equity as software capitalization policy.

On the other hand, Microsoft was known for being conservative in discussing its expectations for future earnings. This pessimistic forecasting communicated to analysts about quarterly/annual earnings and lowered analysts’ expectations. The fact that Microsoft was able to meet or exceed analysts’ expectations in 52 or 53 quarter since going public helped Microsoft’s stock price continuously climbed, which resulted in Microsoft’s high market value of equity.

Low book value of equity and high market value of equity formed a gap.

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

Microsoft expensed all their research and development costs as incurred. The effect of this policy reached its apex in 1999 when the expensed R&D cost was $2.97B and respectfully composed 30% of Microsoft's Total Annual Operating Costs and immediately reduced revenues 15%. This accounting treatment directly resulted in lower net income. The effect which transferred to the cash flow statement and balance sheet would be a lower cash flow from operations and lower retained earnings.

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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     ...

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