EM6602 Accounting for Decision-Making and Control
Microsoft’s Financial Reporting Strategy (HBR 9-100-027)
Toh Wei Hong, Prashant Trivedi, Preethy Varadarajan
The difference between Microsoft’s market value and book value is primarily due to unrecorded intangible assets such as brand value, customer loyalty, human capital, and commercial advantages such as long-term contracts and market dominance. These intangible assets confer Microsoft a tremendous edge over its competitors in future earnings growth.
The market value is often representative of the net present value of expected future earnings. Granted Microsoft’s strong commercial position, its long term earnings growth is likely to hold up, and that is reflected in the market value. As Microsoft’s market value takes into account its potential future earnings, it will inevitably differ from the book value.
Microsoft’s software capitalization policy has the effect of depressing net income.
Reported Net Income
Adjusted Net income
Had Microsoft capitalized its R&D expense after technological feasibility has been established and amortized it over subsequent periods, its net income would have been higher by 6.0% in FY97, 4.0% in FY98 and 2.2% in FY99.
For details of Microsoft’s software capitalization policy on its financial statements, please refer to spreadsheets in appendices.
Microsoft may have chosen to expense all software costs as incurred rather than capitalizing part of these costs because:
1. Doing so improves YOY Growth of Net Income (and Earnings Before Tax)
Based on Microsoft’s reported numbers, net income grew an astounding 57.4% YOY in FY97. Although the YOY %-growth is lower in FY98, it is still an impressive 30.0%. In FY99, the YOY growth is an amazing 73.4%.
Reported Net Income
YOY Growth based on Reported Net Income
| Adjusted Net income
YOY Growth based on Adjusted Net Income
By expensing all R&D cost, net income is depressed, thereby providing a smaller denominator for the computation of YOY %-growth. Therefore, for the same increase in net income, YOY %-growth becomes more pronounced. Mathematically:
| , where n > 0
| Y + n
X = Increase in net income over previous period
Y = Net income of previous period
n = increase in net income had R&D cost been capitalized instead of being expensed
Had Microsoft capitalized the R&D cost and amortized it over subsequent periods, the YOY %-growth would have been more modest in each period. A high YOY %-growth in net income sends a strong signal about the company’s earnings strength.
2. Immaterial difference
We have assumed that 60% of R&D expenditure is incurred after technological feasibility has been established. In reality, this may not be the case. SFAS 86 is very subjective. Being a conservative company, Microsoft might have set more stringent standards for when a project is “technologically feasible” – as a result, post-feasibility R&D expenditure may be very much lower, making it immaterial whether it is expensed or capitalized.
3. Doing so decreases tax burden
Although potential tax impact has been ignored by request, in reality, it cannot. By expensing off R&D upfront, earnings before tax is decreased and hence tax provision (and burden) is smaller. This reduces liabilities and conserves cash for growth projects.
While it can be argued that the amount would have been amortized in future periods anyway (thereby lowering EBT in future periods), it must also be noted that there is a cost to capital....
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