Harvard Business School Case

Microsofts Financial Reporting Strategy

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Microsoft
What is the central issue in the Microsoft case?

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Microsoft

Given Microsofts phenomenal success, why is the SEC investigating the

company?

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Microsoft

As of June 1999 Microsoft had a market capitalization of $460 billion,

while their book value of equity remained only $28 billion.

How is it that Microsoft could have such a large market cap and such a
low book value of equity?

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 Is this how you would expect the balance sheet to look for
the largest company in the world?
1997 1998 1999
Current Assets
Cash 8,966 13,927 17,236
Accts Receivable 980 1,460 2,245
Other 427 502 752
Total Curr. Assets 10,373 15,889 20,223
PP&E 1,465 1,505 1,611
Equity Investments 2,346 4,703 14,372
Other 203 260 940
Total Assets 14,387 22,357 37,156

What are Microsofts most valuable assets?

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 Is this how you would expect the balance sheet to look for
the largest company in the world?
1997 1998 1999
Current Liabilities
Accts Pay 721 759 874
Accrued Comp 336 359 396
Income tax pay 466 915 1,607
Unearned Rev 1,418 2,888 4,239
Other 669 809 1,602
Total Liabilities 3,610 5,730 8,718
Equity
Convertible Preferred 980 980 980
Common Stock 4,509 8.025 13,844
Retained earnings 5,288 7,622 13,614
Total S/E 10,777 16,627 28,438
(see earlier slide)
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Total liab & Equity 14,387 22,357 37,156
Session 8
Microsoft

As of June 1999 Microsoft had a market capitalization of $460 billion,

while their book value of equity remained only $28 billion.

How is it that Microsoft could have such a large market cap and such a
low book value of equity?
- Intangible Assets
- Intellectual Property
- Brand Value
- Human Capital
- Customer loyalty
- Growth opportunities
- Conservative Accounting Choices
Focus of this class 7
Market value = Book value ++

Other: (e.g., growth options)

Market value Identifiable Intangibles

Fair value greater than BV

Net Assets

BV Net Assets (Assets - Liab)

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Back to Microsoft

What accounting tactics did Microsoft use to make their

book value of equity more conservative?

- They did not capitalize software costs

- They were slow in recognizing unearned revenue

These were two controversial issues in the software

industry.

Were these choices within GAAP?

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Research & Development (R&D) Expense

What are the accounting rules for R&D

expenditures under US GAAP?
All R&D expenditures are expensed (none are
capitalized and put on balance sheet).
Logic?
Exceptions:
R&D purchased from another company
Certain software development expenditures

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Capitalizing Software Development
What are the accounting rules for capitalizing
software development costs?
Costs are charged to R&D (i.e., expensed) until the
firm achieves technological feasibility.
Once technological feasibility has occurred, costs
are capitalized and expensed over the useful life of
the software.
Technological feasibility depends on the
completion of a detailed model, and/or a working
model.

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Capitalizing Software Development

How can Microsoft use the capitalization of software

development costs to make earnings more conservative?

Instead of capitalizing, they expense all costs.

How can Microsoft justify this accounting choice?

Microsoft is making choices on when they consider a
product to be technologically feasible to push out any
capitalization costs far into the development cycle.
They could be defining the useful life to be very, very
short.
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Capitalizing Software Development Two Questions

Does Microsofts treatment of software development costs appear

reasonable?
Are their choices to not capitalize any software development costs
resulting in the most relevant accounting numbers?
What do other software companies do?

Does the choice to expense software costs create a material

difference?

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Capitalizing Software Development: Materiality

How would this impact the accounting statements?

Suppose that:
60% of R&D represents software development costs that should be
capitalized, and
the product has a 2 year useful life.
1995 1996 1997 1998 1999
R&D 860 1,326 1,863 2,601 2,970
60% 60% 60% 60% 60% 60%
Capitalizable costs 516 796 1,118 1,561 1,782
R&D to be expensed 344 530 745 1,040 1,188

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 Capitalizing Software Development:
Balance Sheet effects

1995 1996 1997 1998 1999

Capitalized costs 516 796 1,118 1,561 1,782
Prior years cap costs --
Total Cap costs 516
Accum Amt. ---
Net software
development Asset 516

What are total capitalized costs in year 1996?

What is the accumulated amortization in 1996?

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Capitalizing Software Development:
Balance Sheet effects

1995 1996 1997 1998 1999

Capitalized costs 516 796 1,118 1,561 1,782
Prior years cap costs -- 516
Total Cap costs 516 1,312
Accum Amt. --- 258
Net software
development Asset 516 1,054

258 = 516/2

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Capitalizing Software Development:
Balance Sheet effects

1995 1996 1997 1998 1999

Capitalized costs 516 796 1,118 1,561 1,782
Prior years cap costs -- 516 1,312 2,430 3,991
Total Cap costs 516 1,312 2,430 3,991 5,773
Accum Amt. --- 258 914 1,871 3,210
Net software
development Asset 516 1,054 1,516 2,120 2,563

We have estimated the impact on Assets. Is this material?

What other accounts would capitalizing R&D affect?

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Capitalizing Software Development:
Income Statement Effects

1995 1996 1997 1998 1999

R&D (as reported) 860 1,326 1,863 2,601 2,970

R&D to be expensed 344 530 745 1,040 1,188
Amortization Expense ---
Effect on income + 516

This is simply 40% of the original R&D

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Capitalizing Software Development:
Income Statement Effects

1995 1996 1997 1998 1999

R&D (as reported) 860 1,326 1,863 2,601 2,970

R&D to be expensed 344 530 745 1,040 1,188
Amortization Expense --- 258
Effect on income + 516 +538

We get the amortization expense by looking at

the change in accumulated amortization

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 Capitalizing Software Development:
Income Statement Effects

1995 1996 1997 1998 1999

R&D (as reported) 860 1,326 1,863 2,601 2,970

R&D to be expensed 344 530 745 1,040 1,188
Amortization Expense --- 258 656 957 1,339
Effect on income + 516 + 538 + 462 +604 +443

Is this material?
How do these numbers compare to net income in 1999? 1998?
Is this the only conservative accounting choice?

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Unearned Revenue

How does Microsofts decision to defer revenue recognition impact their

financial statements?

- Income is understated.

- Equity is understated.

- Liabilities are overstated (by the amount of deferred revenue).

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Unearned Revenue
How would you estimate the impact of the decision to defer revenue,
assuming all revenue was earned?

Changes in unearned revenue increase (or decrease) income.

Revenue as Unearned Change in Adjusted

reported Rev unearned revenue
(I/S) (B/S) Rev
1995 6,075 --- --- ---
1996 9,050 560 --- ---
1997 11,936 1,418
1998 15,262 2,888
1999 19,747 4,239

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Unearned Revenue
How would you estimate the impact of the decision to defer revenue,
assuming all revenue was earned?

Changes in unearned revenue increase (or decrease) income.

Revenue as Unearned Change in Adjusted

reported Rev unearned revenue
(I/S) (B/S) Rev
1995 6,075 --- --- ---
1996 9,050 560 --- ---
1997 11,936 1,418 858 12,794
1998 15,262 2,888 1,470 16,732
1999 19,747 4,239 1,351 21,098

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Fool.com Article (July 1, 1999)

Microsoft Faces SEC Probe

Software giant Microsoft said it was being investigated by the SEC for
the way it accounts for software revenue. At the same time, CFO Greg
Maffei said the company's fiscal fourth-quarter earnings will be about a
penny a share higher than analysts' estimates as it starts recognizing
more revenue from new products sooner. The change will also add a
penny to earnings for the next fiscal year. According to Maffei, the
accounting change and the SEC investigation are not related.

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Session 8
Fool.com Article (continued)

Microsoft will now recognize 75% to 90% of revenue from new products
up front, instead of 65% to 80%, and spread the rest over the life cycle of
the product

The company will extend the life cycle of Windows operating systems to
three years from two

Microsoft said it is cooperating with the SEC investigation, which

resulted from reports alleging that the company uses "cookie jar"
accounting

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Session 8
What happened?
Changes in Unearned Revenue
In 1999 Microsoft changed its policies it decreased the amount of
revenue it deferred (from 20-35% to 15-25%), but increased useful life
from 2 to 3 years.
2,000

1,800

1,600

1,400

1,200

1,000

800
additions
600
usage
400

200

-
Dec-97 Mar-98 Jun-98 Sep-98 Dec-98 Mar-99 Jun-99 Sep-99 Dec-99
Why would Microsoft choose to be conservative?
Incentives to hide profits?
Antitrust regulation concerns that Microsoft is a monopoly
Other regulators SEC, congress, regulators from other countries are
all interested in Microsofts performance
Competitors Profitable companies encourage entrance into the
market.

Other Incentives?
Financial reporting conservatism as competitive strategy
Avoid complacency, maintain pressure on employees
Force competitors to choose conservative strategies
How does Microsofts Gloom and Doom approach towards financial
analysts fit in?
Incentives to smooth income?

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Microsoft: Take-Aways
Microsoft provides a nice counter-example to income increasing
earnings management.

Microsoft has made accounting choices that decrease earnings and

reduce reported assets.

Provides a nice setting to discuss:

- Intangible assets
- Assets that are not often recognized
- Unearned revenues
- Liabilities that are not directly or necessarily monetary obligations

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