Case Study: Analysis of Microsoft’s Accounting Policies
As the most widely recognized company in the world, Microsoft dominated the home computer operating system market with MS-DOS and Microsoft Windows, a graphical extension for MS-DOS in 1980s.The company was founded by Bill Gates and Paul Allen and went public on March 13th, 1986 with the price of $25.75 per share. Since going public, the company’s performance kept being outstanding. Microsoft not only had a high level growth of revenue and operating income, but also achieved this growth in really short period. The net income of Microsoft always grew more than 15% compared to the same quarter in prior years. Thus, the stock price of the company increased significantly, which was almost 100%, since going public.
However, Microsoft Corporation was under investigation by Securities and Exchange Commission (SEC) for financial reporting problems on June 30th, 1999. The company’s former head of internal auditing, Charles Pancerzewski, charged that Microsoft manipulated its reserve accounts to smooth its earning regularly. By doing so, the company is able to stash accruals during good times and reach them during bad times. In this way, the company can always meet or exceed analysts’ expectations. SEC is the first one to investigate Microsoft’s financial reporting practices. However, the company insisted on saying that they didn’t engage in any improper reporting to manipulate their earnings. And this investigation didn’t affect the company’s stock price much. What caught SEC’s attention was Microsoft’s incredibly stable growth rate of earnings every year and how fast they achieved this growth in such a volatile industry.
Microsoft’s accounting strategy
According to Generally Accepted Accounting Principles (GAAP), there are two essential areas for software developers: how to record software development costs and when to recognize revenue. Microsoft was known for choosing conservative methods of financial reporting for both of them.
To record software development costs, Microsoft chose to expense all costs as incurred rather than capitalizing them. The Financial Accounting Standards Board (FASB) issued a statement regarding to how to expense and capitalize these costs, which is Statement of Financial Accounting Standards (SFAS) No. 86. The statement pointed out that costs incurred in creating a software product should be expensed when incurred as research and development until the software is feasible. After that, all software production costs should be capitalized. But Microsoft thinks this statement doesn’t affect the company materially because software products are short-life products that expensed costs as incurred is almost the same as the capitalization.
For revenue recognition, Microsoft changed their policy in 1996. Before 1996, the company divided the revenue into three categories: revenues from distributors and resellers, revenues from corporate programs and revenues from original equipment manufacturers (OEM). The first one is recognized when the company shipped the products. The second one is recognized when the users installed the software. And the last one is recognized when OEM shipped the products.
Somehow, with the release of Windows 95, Microsoft integrated its Internet technologies, product enhancements, software upgrades and other supports to its existing software without incremental costs to customers. These benefits are subsequent deliverables shipped over the lifetime of the product. So Microsoft started to use an 80/20 revenue recognition policy that means 80% of the revenue is gained when shipped, and 20% is delivered over the remaining lifetime of the products. Therefore, the unearned revenue account’s balance increased significantly after using the new recognition policy. Software Development Cost Capitalization Policy
Under the US GAAP accounting rules about...