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Microsoft’s Financial Reporting Strategy

Microsoft’s Financial Reporting Strategy

Microsoft’s trend for unearned revenue was a steady balance incline from the onset of

reporting the unearned revenue in Q1 1996 all the way through end of year 1999. The balance

rose from $307 million at the start to $4.23 billion by the end of 1999. The unearned revenue

balance incline trend matched a similar trend with revenue and net income at Microsoft over the

same time period.

The FASB gives guidelines for how to treat software development costs that required

capitalization once technological feasibility was established. Microsoft’s determination that the

standard did not affect the company may have been based on two reasons. First, the point at

which the company determined the technological feasibility of their products may have been late

in the development process which in turn made the amount of software costs eligible for

capitalization too small to have a big enough affect on the company’s financial statements.

Secondly, the company may have determined the useful life of the product to be so short as to

make expensing costs as incurred essentially equivalent to capitalization.

Microsoft’s decision to defer revenues came at a time of large growth in revenues which

suggests that their decision to defer revenues was to smooth 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. While the timing of the company’s decision to defer revenues looks to be fishy, the

introduction of Windows 95 provides a real 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.” Sales of these products were improved by these promises and a

portion of these revenues should be deferred into the future. However, to the extent the
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Microsoft’s Financial Reporting Strategy
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.

I do believe Microsoft purposefully gave its analysts a slightly pessimistic overview of

the companies performance. This slight pessimism allowed for Microsoft to always hit their end

of quarter goals and by using the unearned revenue to smooth the bottom line they were able to

show consistent growth, quarter after quarter, and avoid any down quarter or years which kept

the stock price and investor view of the company stable.

Microsoft’s overall financial strategy was to hide profits and avoid complacency. By

hiding these profits through their conservative accounting practices, they gain an advantage over

the competition as well as stay under the radar of regulation. Microsoft also aims to avoid

complacency throughout its organization. Showing consistent, steady growth gives the members

of the organization incentive to keep working harder and avoids the feeling of “having arrived”

and “resting on your laurels”. The SEC obviously doesn’t want companies to leverage

accounting practices as a competitive weapon and want to make sure that investors, the public,

and competitors are not being misled by these accounting practices.

This case is the first I have heard of unearned revenue reporting and how that can provide

an advantage to a company. I am also new to software capitalization and learned that software

development costs can be treated as R&D up to reaching technological feasibility.