Md.
Farhad Kabir
7084590528
MBA 2023 Core C
Marshall School of Business Financial Accounting
Microsoft’s Financial Reporting Strategy
Assignment
1. Estimate the amount of quarterly revenue that would have been reported in each
quarter from 1996 to 1999 if Microsoft had not adopted its new revenue
recognition policy
Unearned Adjusted
Year/ Qs Revenue Reported Revenue Adjustment Revenue % Increase
Q1 307 2085 307 2392
Q2 495 2287 188 2457
Q3 545 2311 50 2361
Q4 560 2367 15 2382
TOTAL
1996 560 9050 560 9610 6.20%
Q1 651 2405 91 2496
Q2 1013 2808 362 3170
Q3 1285 3365 272 3637
Q4 1418 3358 133 3491
TOTAL
1997 1418 11936 858 12794 7.20%
Q1 1671 3334 253 3587
Q2 2038 3792 367 4159
Q3 2463 3984 425 4409
Q4 2888 4152 425 4577
TOTAL
1998 2888 15262 1470 16732 9.60%
Q1 3133 4193 245 4438
Q2 3552 5195 419 5614
Q3 4195 4595 643 5238
Q4 4239 5764 44 5808
TOTAL
1999 4239 19747 1351 21098 6.80%
2. What effect(s) did Microsoft's revenue recognition policy have on its financial
statements (i.e., Balance Sheet, Income Statement, and Statement of Cash
Flows) for fiscal years 1997, 1998, and 1999? Ignore any potential tax effects.
Md. Farhad Kabir
7084590528
MBA 2023 Core C
The income statement showed muted revenue growth and net earnings because a
major chunk of unearned revenue was kept in abeyance over 24 months period, in
which Microsoft presumable wanted to give more updates and other unaccounted
enhancements in their product offerings. Although the balance sheet had cash
assets that are accounted completely, the liability portion increased significantly
for each passing quarter. And the growth in net earnings didn’t truly reflect the
cash assets in their balance sheet because it was being offset by increase in
liabilities. In Statement of Cash Flows, there are no changes in cash flow from
operations because we add back the unadjusted revenue back in the table.
3. Why do you think Microsoft decided to defer a portion of its revenue
beginning in fiscal 1996?
The company’s decision to defer revenues came at a time of significant growth in
revenues— suggesting that the company’s decision to defer revenues was partially
to dampen or “smooth” the company’s revenue growth. The company’s decision
to defer revenue had the effect of reducing reported revenue growth from 88% to
64% in the first quarter of 1996 and increasing revenue growth from 4% to 15% in
the first quarter of 1997. Even as reported the first quarter of 1997 represented the
lowest quarterly revenue growth in the company’s history. While the timing of the
company’s decision to defer revenues appears particularly opportune, the
introduction of Windows 95 to the market provides a legitimate reason for the
decision. As described in the case, the company expected to integrate its Internet
technologies into both Windows 95 and Office 97 “at no additional cost to
customers.” Arguably, then, sales of these products were improved by these
implicit promises and a portion of these revenues should be deferred into the
future. However, to the extent the development costs of providing these
enhancements have already been incurred and expensed under the company’s
current treatment of software development costs, the company’s deferral of
revenues exaggerates the mismatching of expenses with revenues. Still, the
company’s policy on revenue recognition is more consistent with accrual
accounting than is the company’s policy on software development expenses.
4. In your opinion, what is Microsoft's overall financial reporting and
disclosure strategy? Why do you think they adopted this strategy and why
was the SEC concerned about it?
1. Hiding profits—Microsoft’s phenomenal success may have provided them with an
incentive to hide their success from regulators and competitors. Given the
company’s history with regulatory intervention, there is likely a strong incentive
for them to dampen their performance. However, it should be noted that the
company’s software capitalization policy occurred prior to any serious regulatory
intervention.
2. Signaling—By selecting conservative accounting policies and still reporting
strong earnings numbers, Microsoft is able to signal their financial strength. In
other words, they are able to demonstrate their ability to take the “hit” to earnings
and still provide strong results.
3. “Competitive weapon”—As an industry leader, Microsoft has the ability to
influence the accounting policies and practices that develop within the industry. In
Md. Farhad Kabir
7084590528
MBA 2023 Core C
fact the AICPA’s subsequent SOP on software revenue recognition arose out of
Microsoft’s original policy decision. As the strongest player in the industry,
Microsoft can make it more difficult for other companies to show strong
performance by setting norms that reduce earnings and assets.
4. Avoiding complacency—This argument is the subtlest of the four and suggests
that the company dampens its earnings performance to avoid the potential for
complacency that often accompanies financial success. The company’s philosophy
of fostering a sense of “constructive paranoia” about its competitive position and
Gates’ policy on maintaining large cash balances are both consistent with this
argument. The argument is perhaps a better explanation for the company’s
tendency to “talk down” analysts’ expectations rather than as an explanation for
selecting conservative accounting policies, but the argument could certainly be
made for both phenomena.
5. The syllabus includes excerpts from the 2004 Annual Report of Computer
Associates International, Inc., announcing the firm’s decision to restate
certain financial data to properly reflect the timing of the recognition of
license revenue (see also the Wall Street Journal article, “CA Pushes Out
Sales Executive, Restates Revenue”).
(a) What were Computer Associates’ controversial revenue recognition
policies? What effect(s) did these policies have on Computer Associates’
financial performance?
Computer Associates incorrectly reported revenues for fiscal year 2000 and 2001
(ending on 31st March of respective year) by prematurely recognizing the revenues
of contracts even though they were not signed, sometimes backdating the
contracts, and keeping the accounting open, and not even getting countersignature
done within the same period
Also, there were not adequate systems and controls in place to ensure timely
recognition of revenues in each quarter and financial year.
(b) How does Computer Associates’ financial reporting strategy compare to
that of Microsoft? In your opinion, which company’s earnings are of higher
quality?
Financial reporting strategy of Computer Associates spells out malafide intentions
of the executives, including CEO, because these executives received fat
compensation bonuses based on continued stock price increase. And the
executives purposely did the same by not fulfilling their fiduciary responsibility.
Microsoft, on the other hand, never showed incorrect realization of premature
realization of such revenues in their income and balance statement.
Microsoft’s earnings are of higher quality. Although after correcting all the
mistakes and correctly making changes in Electronic Associates’ balance sheet
and income statement didn’t significantly impact the revenues or net earnings, the
improper practices followed at EA clearly tell that their quality is low compared to
Microsoft’s statements.
