Microsoft Financial Reporting Strategy
1. What are the motifs of Microsoft treated the amount that they spend in R&D as part of the expenses. Microsoft expense all costs until it has completed the activities of development process which is planning, designing, coding and testing. This is necessary for them to establish standard that it can produce the products to meet its design specification. There are guideline provided by FASB on treatment of R&D cost require capitalization once technological feasibility established. Microsoft determines the standard on nonfeasible material does not effect to company. They also determine the technological feasibility of their product may have been sufficiently late in the development process. Secondly, the useful life of the product to be shortened as to make expensing costs as incurred essentially equivalent to capitalization. Allowing a company to capitalize rather than expense its R&D costs opens the door for a manipulation of earnings. For instance, a company capitalizing a large R&D charge shows better earnings results than a company that does not capitalize. Furthermore, capitalization of R&D expenses events out earnings, an unrealistic assumption because management does not know if its current capital outlays will lead to a future benefit to earnings. Like marketing expenses, but unlike capital expenditures, R&D expenses are subtracted from revenues every year directly. Therefore, accountants treat R&D spending as an expense rather than as an investment, though there is continuous debate over whether this is the correct classification. An investor looking at companies with large R&D expenditures should think hard about whether a single company's R&D spending is an expense or whether it is an investment. There are two reasons why accounting rules treat R&D outlays as expenses: i. First it is a cruel fact of life that not all R&D outlays lead to the development of marketable products. In fact a relatively low percentage of such outlays lead to successful products. ii. A second problem in treating R&D costs as assets involves deciding their useful life. Assuming that successful R&D costs can be identified, over what period of time do we spread or amortize these costs? If the R&D costs lead to a patent we could simply use the life of a patent as our guide. But what really matters is the life cycle of a successful new product, not the period of patent enforceability.
2. What happen if Microsoft treated that amount as part of their total asset? Discuss.
When we treat R&D expenses as capital expenditures, we have to maintain consistency and treat cumulated R&D expenses as an asset. The simplest way to do this is to cumulate the after-tax research and development expenses over time and create a research asset. This asset will then be amortized over time, with both the length of the amortization period and the amortization schedule being determined by the nature of the research expenses, and the estimated time until there is a payoff to the investment. Thus, for pharmaceutical companies where FDA approval can take as long as a decade, the research asset will be amortized over an extended period. In contrast, for high technology firms where the payoff is much sooner, the research asset will have to be amortized over a shorter period. For Microsoft’s case, let say we 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.
R&D recognized on the I/S
A
1995 860
Adjust to 60% of the R&D expense every year and to amortize it with SL in 2 years (A X 60%)
B
516
Capitalized Development Costs (Total B)
C
Amortization Expense
258 796
1,054
0 398 1,118
1998 2,601
0 559 1,561
1999 2,970
0 780 1,782
1,516
2,120
2,562
D
656
957
1,339
Development Cost expensed (60% R&D)
B
1,118
1,561
1,782
Reduction in profit B/C of expensing Develop. (D-B)
E
-462
-604
-443
-8.70%
-8.50%
-3.70%
As a % of reported profit before taxes
516
1996 1,326
YEAR 1997 1,863
If accounting rules allowed the treatment of R&D costs as assets, management would be sorely tempted to record both unsuccessful and successful outlays as assets. This would lead to the overstatement of assets, the understatement of expenses and in turn the overstatement of income. Even if management were neutral and fair minded it is often impossible to predict which R&D costs will lead to successful products and which will not. Determining the answer to that question can have a large impact on how the company is valued. Capitalization allows a company to spread the cost of an asset into future periods. For example, depreciation allows a company to spread the cost of its tangible assets over an estimated useful life. In contrast, R&D is an expense that may or may not lead to an asset. For example, a chemical company may spend a significant amount of R&D and expect it to generate $1 billion in sales over. However, if the product produced does not meet standard approval, it will never come to market.
