Microsoft's Financial Reporting Strategy Case Solution

Question 2A

The detailed calculations for the R&D expenses are shown in the following table:

As depicted by the analysis, the net profit on the income statement will decrease in the prescribed time. Additionally, the reported retained earnings balance on BS will also be less.

Question 2b

Originally, the criterion provided by FASB dictates that the software development costs can only be capitalized once the technological feasibility was established. However, the policy of Microsoft reported that the guidelines provided by FASB have no material effect in the financial statements. The first line of reasoning follows that Microsoft projects its technological feasibility to occur at the latter half of the project. This implies that, at the time when costs are eligible to be capitalized, their absolute figure is so small that it does not disturb the financial ratios of the company. Moreover, Microsoft could also have projected the useful life of their products to be short-lived.

Question 3A

The effect of the change in the revenue recognition policy is depicted in the following table.

As a result of the change in the revenue recognition policy, the revenue will change by 6.19%, 7.19%, 9.63%, and 6.84% respectively in the year 1996, 1997, 1998 and 1999.

Question 3B

The first and foremost motive behind the deferral of the revenue arises from the notion of ‘smoothing out’ of the revenues. One can furnish the example of the sales of new software, Windows 95. It should be noted that the major portion of the revenue from the sale of windows was attained in 1995 when the customers buy the product or place an order. The frictional increase in the revenues will post huge revenue on the balance sheet. However, in the following years, the revenue is expected to decrease as no major software is expected to be introduced in the market. This inconsistency in the revenues will not only cast a negative externality on the share price, but the earning, ratios and forecasts will also suffer. Hence, the shrewd step to defer the revenue may be related to the idea of smoothing out the balance sheet and income statement. Secondly, with the introduction of Windows 95, Microsoft also incurred some contractual obligations to provide free of costs services to the customers. Hence, in this situation, the recognition of the entire revenue base will be inconsistent with the accrual concept of accounting. Later, Apple Inc also adopted a similar revenue recognition policy when it introduced the IStore and free updates to the new operating systems for the iPhone users.