Group Case Study “Microsoft’s Financial Reporting Strategy”
Microsoft’s Financial Reporting Strategy ABSTRACT
This case study examines the factors explaining the difference between Microsoft’s market value of equity to book value of equity and overall financial reporting strategies employed at the firm. We analyzed financial information dating from 1985 to 1999 and 2011 annual report provided by Microsoft. We found factors explaining market value of equity are perceived risk and future cash flows. Additionally, we concluded the firm’s financial reporting practices were used to create a distorted impression of business performance to seek certain results. Factors Explaining the Difference between Market and Book Value of Equity: The difference between market value to book value of equity can be explained by the former being based on future expectations held by investors while the latter is formulated on historical data which has already impacted the firm. Finance theory explains a firm’s market value of equity is the result of investors perceiving three variables: managerial actions, economic environment, and political climate affecting a firm’s overall risk and future cash flows. While book value of equity is formulated by identifying residual interest left to stockholders after deducting liabilities which is largely attributed to the past (Ehrhardt ,2011).
Figure 1 - 1: Determinates of Stock Prices
Managerial Actions, The Economic Environment, and the Political Climate
"Perceived" Expected Future Cash Flows Figure 1 - 2: Determinates of Book Value of Equity
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Microsoft’s Financial Reporting Strategy
Accounting research indicates “… factors that most affect the type of influence exercised by both book value & cash flow on the market price are a firm’s size and the speed of asset turnover. Thus, the larger the firm, the greater the influences on book value have on share price, while the faster asset turnover factor is associated with the influence of cash flow” (Gallizo & Salvador ,2006). In comparing the exhibits below, we can see correlated earnings performance to stock price which links positive earnings performance to market value of equity. Exhibit 1-3 Microsoft Corp., Financial Performance since Initial Public Offering 20,000 18,000 16,000 14,000 12,000 $'s in millions 10,000 8,000 6,000 4,000 2,000 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Year Source: Microsoft Corp. Financial History Pivot Table, available at http://www.microsoft.com/msft/history.htm Revenue Operating Income Net Income
Exhibit 1-4 Microsoft Corp., Stock Performance since Initial Public Offering
Source: Microsoft Corp. Stock Price History Interactive Chart, available at http://investing.money.msn.com/investments/equity-charts
Microsoft’s Financial Reporting Strategy Assessment of Revenue Recognition Policy:
In 1996, Microsoft began to take a uniquely conservative revenue recognition approach on two selected product sales: Operating systems and Office 97. The company decided that given its strategy to integrate an internet browser, telephone support, technical support, and product enhancements into its products. Deferring revenue in the following manner: • 20% of the revenue from the sale of operating systems deferred over the two year product’s life cycle. • 20% of the revenue from the sale of Office 97 deferred over the 18-month product life cycle. This revised recognition policy resulted in unearned revenue growing from $1.4 billion to $4.2 billion from 1997 to 1999 (Mausumoto & Bowen, 1999). Figure 2 - 1: Unearned Revenue balance at year end from 1997 to 1999 ($'s in millions) Unearned revenue balance, at June. 30 Growth of unearned revenue (1997 base year) Year-over-year growth 1997 1,418 100% 1998 2,888 104% 204% 1999 4,239 199% 147%...
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