MSFT-Financial-Reporting-Strategy

HarvardBusinessSchool9-100-027Rev.February16,2000ProfessorDawnMatsumotoandProfessorRobertBowenoftheUniversityofWashingtonpreparedthiscasefrompublicsourcesasthebasisforclassdiscussionratherthantoillustrateeithereffectiveorineffectivehandlingofanadministrativesituation.Copyright©1999bythePresidentandFellowsofHarvardCollege.Toordercopiesorrequestpermissiontoreproducematerials,call1-800-545-7685,writeHarvardBusinessSchoolPublishing,Boston,MA02163,orgoto—electronic,mechanical,photocopying,recording,orotherwise—withoutthepermissionofHarvardBusinessSchool.1Microsoft'sFinancialReportingStrategyWeareacompanyknownforbeingconservative.—GregMaffei,CFO1OnJune30,1999,duringaconferencecallwithanalysts,MicrosoftCorporationannouncedthatthecompanywasunderinvestigationbytheSecuritiesandExchangeCommission(SEC)forcertainaccountingpractices.Althoughtheexactfocusoftheinvestigationwasnotdisclosed,thecommonbeliefwasthattheinvestigationinvolvedthecompany’sdeferralofrevenueandotherundisclosedreserveaccounts.2CompanyBackground3AsthedeveloperandmanufacturerofproductssuchastheWindowsoperatingsystem,theInternetExplorerwebbrowser,andtheMicrosoftOfficesuiteofapplications,Microsoftwaseasilythemostwidelyrecognizedsoftwaredeveloperintheworld.Thecompany’shistoryhadbeenwelldocumented—inarticles,books,documentariesandevenamade-for-televisionmovie,“PiratesofSiliconValley.”BillGatesandPaulAllenfoundedthecompanyin1975,withtheideathatonedaytherewouldbe“acomputeroneverydeskandineveryhome.”Thecompany’sbigbreakcamein1980whenitnegotiatedwithIBMtoprovidetheoperatingsystemforIBM’snewpersonalcomputer.TheresultwasMS-DOSandbythemid-80s,Microsoftdominatedthemarketforoperatingsystems.ThecompanywentpubliconMarch13,1986at$25.75pershare.AsofJune30,1999,oneshareofMicrosoftpurchasedattheinitialpublicofferingwasworthalmost$13,000.Bythistime,thecompanyalsohadthehighestmarketvalueofanyU.S.publiccompany(approximately$460billion)anditsCEO,BillGates,wastheworld’swealthiestindividual.Sincegoingpublicin1986,thecompany’sfinancialperformancehadbeennothingshortofextraordinary(seeExhibits1and2).Revenueandoperatingincomegrewanaverageof43%and1“MicrosoftFacesInvestigationBySECOverItsAccounting,”WallStreetJournal,July1,1999.2Ibid.3ThisbriefhistoricalaccountofMicrosoft’sdevelopmentborrowsfrom“Microsoft,1995(Abridged),”Harvardcasenumber9-799-003,byProfessorsTarunKhannaandDavidYoffie.100-027Microsoft'sFinancialReportingStrategy249%peryear,respectively.AsofJune30,1999,thecompanyhadcashandshort-terminvestmentsof$17billion,assetstotaling$37billionandbookvalueofequityequalto$28billion(seeExhibit3).Perhapsevenmoreimpressivethanitsastoundinggrowthwasthesteadywayinwhichthecompanyachievedthisgrowth.Ineveryquartersincegoingpublic,thecompany’snetincomeincreasedfromthesamequarterintheprioryearanditsrevenuenevergrewlessthan15%.Also,thecompanymetorexceededconsensusanalysts’forecastsofearningsineveryquarterexceptone(backin1988).4Thisstablegrowthwasreflectedinthecompany’sstockprice(seeExhibit5)whichincreasedsteadilyfrom1986throughmid-1999.Consideringtherelativelyvolatileindustryinwhichthecompanyoperated,Microsoft’sabilitytoconsistentlyreporthigherthanexpectedfinancialperformancewasclearlyanimpressivetrackrecord.Microsoft’sperformancewasevenmoreremarkablewhenconsideringthefactthatthecompanywasknownforbeingrelativelyconservativeinitsaccountingchoices.WhileGenerallyAcceptedAccountingPrinciples(GAAP)establishbasicstandardsbywhichcompaniesreporttheirfinancialresults,thestandardsareoftensufficientlyvaguetoallowmanagerialdiscretionindeterminingtheappropriateaccountingtreatmentforagiventransaction.TheflexibilityinGAAPisprovidedtoallowmanagerstobetterrepresenttheeconomicsubstanceofagiventransaction.Forsoftwaredevelopers,therewereatleasttwokeyareasinwhichthestandardsatthetimeallowedflexibility—softwaredevelopmentcostsandrevenuerecognition.Inboththeseareas,Microsoftchosearatherconservativemethodofreporting.SoftwareDevelopmentCostsUnderGAAP,accountingforsoftwaredevelopmentcostsmustconformtoStatementofFinancialAccountingStandards(SFAS)No.86,AccountingfortheCostsofComputerSoftwaretoBeSold,Leased,orOtherwiseMarketed.TheFinancialAccountingStandardsBoard(FASB)issuedtheStatementinAugust1985asaresponsetoindustryconcernsthattreatingsoftwaredevelopmentcostsinasimilarfashiontoresearchanddevelopmentcosts(i.e.,expensedasincurred)ledtoaseveremis-matchingofcostsandrelatedrevenue.TheStatementcoversbothinternallydevelopedsoftwareaswellaspurchasedsoftware.AsummaryoftherequirementsfromtheStatementfollows:ThisStatementspecifiesthatcostsincurredinternallyincreatingacomputersoftwareproductshallbechargedtoexpensewhenincurredasresearchanddevelopmentuntiltechnologicalfeasibilityhasbeenestablishedfortheproduct.Technologicalfeasibilityisestablisheduponcompletionofadetailprogramdesignor,initsabsence,completionofaworkingmodel.Thereafter,allsoftwareproductioncostsshallbecapitalizedandsubsequently