Microsofts Financial Reporting Strategy Harvard Case Solution & Analysis

Question No. 1: What are the factors that likely explain the difference between Microsoft’s market value of equity and its reported book value of equity?


The name of Microsoft is very well known to everyone. The company started its business on April 4, 1975. Its founders were Bill Gates and Paul Allen opened this company to sell basic interpreter and Altair 8800.  The company advanced to the height in the industry of modern computer software and design in no time. In June 1999, after a conference call with the company’s analysts, The Microsoft Corporation declared that the company was in trouble as they were investigated by the Securities and Exchange Commission (SEC) over some ambiguous accounting practices by the management. As stated, the investigation was most concerned over the deferral of revenues and other undisclosed reserves accounts shown in the Income Statement and Balance Sheet of the company.

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 type 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 accounting 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. As the financial theory stated that the company’s financial position is assessed by the investors on the basis of the three different variables namely: economic environment, managerial actions and political climate affecting a firm’s overall future risks associated with the future cash flows of the company. On the other hand, the book value was recorded on the basis of identified residual and remaining interest left to the shareholders and members of the company after subtracting payables, as the claim that the creditors must be on top.

Another reason behind the current flaws in the financial statements of the company was the influence of the cash flows and book value over the market price of the shares and the continuous rise in the asset turnover ratio. As, the larger the size of the firm, the greater the influences of book value have on the share price. On the other hand, the higher asset turnover ratio was more associated on the influence of cash flow.

Question No. 2: What effect did Microsoft’s software capitalization policy have on its financial statements? Ignore any 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 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.


Refer to the appendices.

(b): Why do you think Microsoft chose to expense all software costs as incurred rather than capitalizing a portion of these costs?


In 1985, in the statement issued by the Financial Accounting Standards Board (FASB), stated that the costs incurred internally in creating software, shall be charged to the income statement or profit or loss as expense for the period in which it was actually incurred as research and development until the technological feasibility has been recognize, and unless the technological feasibility is established over the completion of the product. After that, all cost associated with the production of the software shall be capitalized and consequently shall be recorded at the lower of the realizable value and unamortized cost. On the other hand, the capitalized cost must be amortized on the basis of the future and current revenues. On the other hand, the management of the Microsoft Corporation evaluated the statement as immaterial, as they thought that it would not materially affect the Company’s financial statements. The management assumed the above practice on the basis of two different reasons.......................

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Examines the overall financial strategy of the company Microsoft, studying accounting treatment of the company of the two accounting issues - software capitalization and revenue recognition. For both issues, the company selects accounting methods that are relatively conservative. We also discuss the issue of managing the expectations of analysts and trends Microsoft, to provide analysts with a very conservative expectations for the future. Provides a forum to discuss the possible causes of accounting and disclosure choices Microsoft, and also discusses the recent investigation by the Securities and Exchange Commission in the Microsoft practice of accounting. "Hide
by Dawn Matsumoto, Robert Bowen Source: HBS Premier Case Collection 12 pages. Publication Date: September 13, 1999. Prod. #: 100027-PDF-ENG

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