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1 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. Microsoft’s rationalization to this approach was that they provided after purchase services to customers such as Internet-based technical , telephone , 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 ing 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, Microsoft’s 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 ing 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.

2 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 Microsoft’s 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 Microsoft’s policy of moderate and conservative ing policies and procedures also has a negative effect on the company’s 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 company’s financial position. 5. What effect did Microsoft’s software capitalization have on their financial statements? Ignore the potential tax effects. a. 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 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 sheet.

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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 Microsoft’s 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.

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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 Microsoft’s fiscal 1997, 1998 and 1999financial statements? By recognizing revenue and not capitalizing costs that were allowable, Microsoft deflated the size of their company’s book value and earnings. In doing so, it can be assumed that Microsoft’s 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 Microsoft’s revenues performance, which increased their likelihood of achieving the lessened results. Also, by achieving analyst’s expectations, Microsoft could effectively raise their stock price, being that they overachieved on expectations. 9. Describe Microsoft’s overall financial reporting strategy. Why had the company adopted this strategy and why was the SEC concerned about it? Microsoft’s 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. Microsoft’s rationalization to this approach was that they

6 provided after purchase services to customers such as Internet-based technical , telephone , 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.