Microsoft Accounting Strategy

Microsoft‘s primary operations has been developing and manufacturing of the software products. As a company, it has shown a very stable growth in terms of revenues and profits, thus enabling better than industry share price increase over more than a decade.

With respect to the primary operation of software development and the task to financial reporting the two areas that were required to be established were:

1. Treatment of Software Development costs.
2. Revenue recognition policy.

As per the statement issued by Financial Accounting Standards board in 1985, the cost that is incurred for the research and development of software is to be considered as “expense” till the work product’s technical feasibility is determined or the working model is complete, at which point, all further costs will need to be capitalized and reported by following general principle of amortization.

Microsoft considered that the statement SFAS no 86, didn’t materially affect the company and hence there was no change required to the company’s accounting practice. This is because Microsoft’s main operating costs involved research and development costs and the production costs were comparatively insignificant. As matter of Microsoft’s accounting policy, prior to 1996, it recognized revenues when the product was shipped to distributors, resellers or original equipment manufacturers or in case of corporate license programs, the revenue was recognized when the users installed the product.

However with launch of integrated Internet technology products in 1996, Microsoft had a change in its accounting practice. Microsoft considered that the new Internet technology products were tightly integrated with its existing blockbuster products namely – Windows operating system and Office 97. Per Microsoft, part of the sales of these products need to be recognized differently since there are future deliverables/upgrades/fixes to the related products and a value needs to be put on the same. Accordingly Microsoft started a practice wherein it accounted 20% of its sales as Unearned revenue” which was recognized as “revenue” over the useful life of the product.

Microsoft viewed this as fair practice in line with Statement of Position 97-2 issued by American Institute of Certified Public Accountants. However this change in accounting practice didn’t go well with a section of investment analysts and Security Exchange Commission. This was because:

1. Investment analysts viewed that the huge reserve that was created over a period of time as “Unearned revenue” was holding back the company’s true potential. However Bill gates, CEO of Microsoft, considered that a conservative approach is good so as to keep a sufficient cash reserve in the best interests of employees and the industry fluctuations.
2. SEC viewed it as a deliberate attempt to misrepresent the revenues so as to create a “cookie jar” which can be used for reporting better than actual numbers in bad times and correspondingly lowering the revenues earned during better times, thus giving an impression of smoothened earnings growth.

Accordingly SEC initiated its first ever investigation into Microsoft’s financial reporting practices since it viewed Microsoft’s practice as an intention to establish hidden reserve, manipulate its reported earnings in order to meet expectation and incorrectly reflect economics in the financial statements. The news of the investigation was though downplayed to a large extent by analysts. Analysis:

1. The possible reason behind Microsoft deciding to not adopt SFAS 86 could be that a higher capitalization would result in higher profit being shown on the profit and loss statement. Microsoft being a conservative company didn’t want to give raise expectation of the analysts and investors by giving an impression of higher profits. Hence since the “technical feasibility” could be justified either ways using discretion, Microsoft chose to indicate that a larger proportion of the costs were incurred prior to establishing technical feasibility and hence the other costs related to the development are not materially significant, hence the entire costs is shown as expense.

   Thus using the justification that technological feasibility of product occurred sufficiently late in the development process and useful life of the product is short-lived, Microsoft was able to argue in favor of not “capitalizing” the costs and expensing them instead and use this for reporting higher expenses.

2. The argument for Microsoft deferring to recognize a part of revenue at the point of sales was that say when a customer is buying software in 1996, they’re also buying the right to upgrades and customer support in 1997 and 1998. Hence a part of the sales needs to be considered as “Unearned revenue”. However the real reason for stashing a huge reserved as “Unearned revenue” appears to be meeting revenue and profit guidance. Microsoft has been the dominant player in the IT sector and hence it was able to stash enough reserves over good quarters by keeping a part of its sales as “Unearned revenue” that it could easily tide over a few bad quarters. The below graph gives a pictorial idea of the way how such a practice of deferring revenue can help in smoothening the reported revenue and hence manage external expectations/guidance.

The above hypothetical graph shows how the “Unearned revenue” can be used to smoothen the earnings reported, so as to make the desired effect on the analysts and stock market. While the dotted line represents actual earning and has fluctuation, the smoothened line represents revenue reported by Microsoft using “Unearned revenue” and depicts a comparatively consistent growth. Overall capitalization practice appears to be more consistent with cash-basis accounting while revenue recognition practice appears to be more consistent with accrual accounting.

Broadly I consider both these policies as conservative as they result in reporting lower assets, higher liabilities and less income in the current period. While Microsoft has made some changes to its accounting practice since 1999(pursuant to AICPA SOP 98-9, by decreasing the percentage of revenues reported as “unearned revenue” and increasing the useful product life, it certainly is not an exceptional company in adopting such practices.

Companies like General Electric are also known to be conservative while reporting their revenues and employ creative accounting techniques.