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Microsoft Financial Reporting Strategy Case 1. Why did did Microsoft Microsoft want to recogniz recognizee revenue revenue conservatively? conservatively?
In the case, Microsoft is exercising a revenue recognition policy for their software revenues that allocates 80% of revenues generated and the other 0% of revenues is a!orti"ed over the #year expected useful life for its products$ hus, &'( of the 0% deferred revenue is to )e recogni"ed on a !onthly )asis for the #year period following the initial sale$ Microsoft*s rationali"ation to this approach was that they provided after purchase services to custo!ers such as Internet#)ased technical support, telephone support, and unspecified produc t enhance!ents and it is therefore allowa)le to recogni"e 0% of revenue over that #year period$ Microsoft chose to recogni"e revenue in such a conservative !anner in the hopes that the deferred revenue of 0% fro! software sales can )e a!orti"ed over a #year period and provide steady inco!e growth for every +uarter$ In other words, words, Microsoft sought to s!ooth- their inco!e so that +uarters + uarters with high revenue would not )e extre!ely large increases and so that so!e of those revenues could )enefit lowering perfor!ing +uarters$ .y a!orti"ing the 0%, Microsoft is is a)le to apply a portion of that a!ount of revenues to slower +uarters and years and !aintain a steady increase of inco!e over ti!e$ Microsoft executives consistently selected conservative accounting practices, li/e their way of recogni"ing revenue for software sales$ Co!)ine the s!oothing of revenues and inco!e over several +uarters with the panic and dire tal/s that Microsoft xecutives gave at annual shareholder !eetings, a nd it resulted in a fairly achieva)le consensus* analyst expectations on earnings for Microsoft, which they achieved all )ut )u t one$ hus, Microsoft*s stoc/ price )enefitted fro! lower ana lyst expectations, in the sense that they al!ost alwa ys !et or exceeded the!$ 2. Why did they SEC SEC investigate investigate the accounting accounting practices practices of Microso Microsoft? ft?
he SC chose to investigate Microsoft due to their revenue recognition policies and the pro)le!s that were associated with it$ 1t this !o!ent in ti!e, !any co!panies were participating in practices si!ilar to that of Microsoft and it )egan to draw the attention of the SC$ he SC Chair!an, 1rthur 2evitt said, Increasingly, I have )eco!e concerned that the !otivation to !eet 3all 3all Street earnings expectations !ay )e overriding co!!on sense )usiness practices$- 3hat he !eant )y this is that the the revenue recognition practices that Microsoft was using was an atte!pt )y Microsoft to s!ooth their inco!e over the course cou rse of a year, which loo/s )etter to investors and to !eet 3all Street expectations$
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3. nder the new !SC "#"$ how should Microsoft recognize the revenue of its software sales?
4nder 1SC 505, Microsoft will apply the revenue generated fro! their software sales )ased on what o)ligations it has in a contract and what their esti!ated values are$ Meaning that if Microsoft is not contractually o)ligated to update the Internet explorer, it can no longer attri)ute any revenue generated fro! the sale towards it$ 6n the other hand, for the li/es of costu!er services, Microsoft can deter!ine reasona)le esti!ates on their standalone values and a!orti"e that portion of deferred revenue over the esti!ated useful life of the software$ ($ What are the %ey factors that li%ely e&plain the difference 'etween Microsoft(s value of e)uity and its reported 'oo% value of e)uity? It is o)served that the factors which are responsi)le for the difference )etween the !ar/et value of the e+uity and the )oo/ value of the e+uity were the non#recording of the intangi)le assets correctly, i$e$ hu!an capital, )rand value, goodwill of the co!pany and custo!er loyalty$ hat was the !ost o)vious reason )ehind the pro)le!$ Since, these types of intangi)les were the reason )ehind the tre!endous growth of earnings in the future, which nor!ally evaluate the !ar/et v alue of the fir!$ 6n the other hand, it was noted that the Microsoft*s policy of !oderate and conservative accounting policies and procedures also has a negative effect on the co!pany*s )oo/ value of the e+uity$ 1nother reason was that the !anage!ent of the Microsoft Corporation was !ore concerned a)out the historical practices rather than going for the future expectations, which has severely affected the co!pany*s financial position$ 7$ What effect did Microsoft(s software capitalization have on their financial state*ents? +gnore the potential ta& effects. a$ !ssu*e that "#, of Microsoft(s research and develop*ent e&penses were incurred after technological feasi'ility was esta'lished$ that the average product life was two years$ and that the co*pany 'egins a*ortizing at the 'eginning of the following year. Esti*ate the effect of capitalizing software costs on Microsoft(s fiscal 1--$ 1--/ and 1--- inco*e state*ents and 'alance sheet.
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)$ Speculate as to why Microsoft chose to e&pense all software costs as incurred rather than capitalizing a portion of these costs. Microsoft and other software co!panies were re+uired )y the F1S. to expense all costs related to R9 in the period incurred until the research was technologically feasi)le$ 1fter that, all costs associated with the production of the software can )e capitali"ed and a!orti"ed at the lower of the reali"a)le value and una!orti"ed cost$ 6nce this point was reached Microsoft dee!ed that the a!ount of R9 costs that could )e capitali"ed was i!!aterial and would not significantly i!pact their financial state!ents in any wa y$ 5$ What effect did Microsoft(s revenue recognition policy have on its financial state*ents? a$ Esti*ate the a*ount of revenue that Microsoft would have reported in each )uarter fro* 1--" through 1---.
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)$ Speculate as to why Microsoft chose to defer a portion of its revenues in 1--". I )elieve that Microsoft chose to defer a portion of its revenues starting I &::5, )ecause they /new that they were perfor!ing extre!ely well and they intended to use the deferred revenue as a )uffer to future years, in the event that perfor!ance levels of Microsoft lessened$ ;$ What was the overall i*pact of these two policies on Microsoft(s fiscal 1--$ 1--/ and 1---financial state*ents? .y recogni"ing revenue and not capitali"ing costs that were allowa)le, Microsoft deflated the si"e of their co!pany*s )oo/ value and earnings$ In doing so, it can )e assu!ed that Microsoft*s intentions were to lower the expectations of analysts and ensure that less difficult expectations would )e placed on their perfor!ance$ Surely if Microsoft had recogni"ed revenue in a less conservative way and capitali"ed the costs that were allowa)le, revenue and perfor!ance expectations fro! 3all Street would have )een higher$ 8$ 0id Microsoft provide its analysts( with infor*ation that was intentionally overly pessi*istic? !re there any 'enefits to the co*pany 'eing outwardly pessi*istic a'out its future prospects?
Microsoft*s overall financial reporting strategy was fairly conservative to onloo/ers$ In the case, Microsoft is exercising a revenue recognition policy for their software revenues that allocates 80% of revenues generated and the other 0% of revenues is a!orti"ed over the #year expected useful life for its products$ hus, &'( of the 0% deferred revenue is to )e recogni"ed on a !onthly )asis for the #year period following the initial sale$ Microsoft*s rationali"ation to this approach was that they
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provided after purchase services to custo!ers such as Internet#)ased technical support, telephone support, and unspecified produc t enhance!ents and it is therefore allowa)le to recogni"e 0% of revenue over that #year period$ he SC was concerned a)out Microsoft due to their revenue recognition po licies and the pro)le!s that were associated with it$ 1t this !o!ent in ti!e, !any co!panies were participating in practices si!ilar to that of Microsoft and it )egan to draw the attention of the SC$ he SC Chair!an, 1rthur 2evitt said, Increasingly, I have )eco!e concerned that the !otivation to !eet 3all Street earnings expectations !ay )e overriding co!!on sense )usiness practices$- 3hat he !eant )y this is that the revenue recognition practices that Microsoft was using was an atte!pt )y Microsoft to s!ooth their inco!e over the course of a year, which loo/s )etter to investors and to !eet 3all Street expectations$
