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Microsoft Financial Reporting Strategy Case

1. Why did Microsoft want to recognize revenue conservatively?
In the case, Microsoft is exercising a revenue recognition policy for their software
revenues that allocates 80% of revenues generated and the other 20% of revenues is
amortized over the 2-year expected useful life for its products. Thus, 1/24 of the 20%
deferred revenue is to be recognized on a monthly basis for the 2-year period
following the initial sale. Microsofts rationalization to this approach was that they
provided after purchase services to customers such as Internet-based technical
support, telephone support, and unspecified product enhancements and it is therefore
allowable to recognize 20% of revenue over that 2-year period.
Microsoft chose to recognize revenue in such a conservative manner in the hopes that
the deferred revenue of 20% from software sales can be amortized over a 2-year
period and provide steady income growth for every quarter. In other words, Microsoft
sought to smooth their income so that quarters with high revenue would not be
extremely large increases and so that some of those revenues could benefit lowering
performing quarters. By amortizing the 20%, Microsoft is able to apply a portion of
that amount of revenues to slower quarters and years and maintain a steady increase
of income over time.
Microsoft executives consistently selected conservative accounting practices, like
their way of recognizing revenue for software sales. Combine the smoothing of
revenues and income over several quarters with the panic and dire talks that
Microsoft Executives gave at annual shareholder meetings, and it resulted in a fairly
achievable consensus analyst expectations on earnings for Microsoft, which they
achieved all but one. Thus, Microsofts stock price benefitted from lower analyst
expectations, in the sense that they almost always met or exceeded them.
2. Why did they SEC investigate the accounting practices of Microsoft?
The SEC chose to investigate Microsoft due to their revenue recognition policies and
the problems that were associated with it. At this moment in time, many companies
were participating in practices similar to that of Microsoft and it began to draw the
attention of the SEC. The SEC Chairman, Arthur Levitt said, Increasingly, I have
become concerned that the motivation to meet Wall Street earnings expectations may
be overriding common sense business practices. What he meant by this is that the
revenue recognition practices that Microsoft was using was an attempt by Microsoft
to smooth their income over the course of a year, which looks better to investors and
to meet Wall Street expectations.

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3. Under the new ASC 606, how should Microsoft recognize the revenue of its software
sales?
Under ASC 606, Microsoft will apply the revenue generated from their software sales
based on what obligations it has in a contract and what their estimated values are.
Meaning that if Microsoft is not contractually obligated to update the Internet explorer, it
can no longer attribute any revenue generated from the sale towards it. On the other hand,
for the likes of costumer services, Microsoft can determine reasonable estimates on their
standalone values and amortize that portion of deferred revenue over the estimated useful
life of the software.
4. What are the key factors that likely explain the difference between Microsofts value
of equity and its reported book value of equity?
It is observed that the factors which are responsible for the difference between the market
value of the equity and the book value of the equity were the non-recording of the
intangible assets correctly, i.e. human capital, brand value, goodwill of the company and
customer loyalty. That was the most obvious reason behind the problem. Since, these
types of intangibles were the reason behind the tremendous growth of earnings in the
future, which normally evaluate the market value of the firm. On the other hand, it was
noted that the Microsofts policy of moderate and conservative accounting policies and
procedures also has a negative effect on the companys book value of the equity. Another
reason was that the management of the Microsoft Corporation was more concerned about
the historical practices rather than going for the future expectations, which has severely
affected the companys financial position.
5. What effect did Microsofts software capitalization have on their financial
statements? Ignore the potential tax effects.
a. Assume that 60% of Microsofts 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 at the beginning of the following
year. Estimate the effect of capitalizing software costs on Microsofts fiscal 1997,
1998 and 1999 income statements and balance sheet.

b. Speculate as to why Microsoft chose to expense all software costs as incurred rather
than capitalizing a portion of these costs.
Microsoft and other software companies were required by the FASB to expense all costs
related to R&D in the period incurred until the research was technologically feasible.
After that, all costs associated with the production of the software can be capitalized and
amortized at the lower of the realizable value and unamortized cost. Once this point was
reached Microsoft deemed that the amount of R&D costs that could be capitalized was
immaterial and would not significantly impact their financial statements in any way.
6. What effect did Microsofts revenue recognition policy have on its financial
statements?
a. Estimate the amount of revenue that Microsoft would have reported in each quarter
from 1996 through 1999.

b. Speculate as to why Microsoft chose to defer a portion of its revenues in 1996.

I believe that Microsoft chose to defer a portion of its revenues starting I 1996, because
they knew that they were performing extremely well and they intended to use the
deferred revenue as a buffer to future years, in the event that performance levels of
Microsoft lessened.
7. What was the overall impact of these two policies on Microsofts fiscal 1997, 1998
and 1999financial statements?
By recognizing revenue and not capitalizing costs that were allowable, Microsoft deflated
the size of their companys book value and earnings. In doing so, it can be assumed that
Microsofts intentions were to lower the expectations of analysts and ensure that less
difficult expectations would be placed on their performance. Surely if Microsoft had
recognized revenue in a less conservative way and capitalized the costs that were
allowable, revenue and performance expectations from Wall Street would have been
higher.
8. Did Microsoft provide its analysts with information that was intentionally overly
pessimistic? Are there any benefits to the company being outwardly pessimistic
about its future prospects?
Yes, they provided overly pessimistic information to analysts and stockholders. This is
beneficial in that investors were more likely to have more achievable expectations of
Microsofts revenues performance, which increased their likelihood of achieving the
lessened results. Also, by achieving analysts expectations, Microsoft could effectively
raise their stock price, being that they overachieved on expectations.
9. Describe Microsofts overall financial reporting strategy. Why had the company
adopted this strategy and why was the SEC concerned about it?
Microsofts overall financial reporting strategy was fairly conservative to onlookers.
In the case, Microsoft is exercising a revenue recognition policy for their software
revenues that allocates 80% of revenues generated and the other 20% of revenues is
amortized over the 2-year expected useful life for its products. Thus, 1/24 of the 20%
deferred revenue is to be recognized on a monthly basis for the 2-year period
following the initial sale. Microsofts rationalization to this approach was that they

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provided after purchase services to customers such as Internet-based technical
support, telephone support, and unspecified product enhancements and it is therefore
allowable to recognize 20% of revenue over that 2-year period.
The SEC was concerned about Microsoft due to their revenue recognition policies
and the problems that were associated with it. At this moment in time, many
companies were participating in practices similar to that of Microsoft and it began to
draw the attention of the SEC. The SEC Chairman, Arthur Levitt said, Increasingly, I
have become concerned that the motivation to meet Wall Street earnings expectations
may be overriding common sense business practices. What he meant by this is that
the revenue recognition practices that Microsoft was using was an attempt by
Microsoft to smooth their income over the course of a year, which looks better to
investors and to meet Wall Street expectations.