1. Market value of equity and book value of equity are substantially different for nearly every company.

Book value of equity treats the value of the equity as the reported assets less the reported liabilities. A company with substantial (unreported) intangible assets will always be priced higher than the book value of the equity. The market also takes into account the efficiency or return generated by management on the assets. A company with a very high ROE number will be trading for substantially larger than the book value of assets. At the time of this case, for the year ended Dec. 31, 1999, MSFT had 2,470,000,000 shares of common stock outstanding and a book value of equity of 28,438,000,000 for a BVPS of 11.50. The stock closed for trading over 116.00, yielding a significant premium on the stock over book value. For comparison, as of Q2 2011: MSFT has a Price/Book ratio of 3.98, while its largest competitors AAPL and GOOG have P/B ratios of 5.35 and 3.39 respectively. In MSFTs case, investors were very excited about the company and believed they would continue their excellent run of both beating earnings estimates and delivering year-over-year growth in revenues and net income. In an industry like software, a substantial portion of revenues are driven by intangible assets (such as software costs, and brand presence) which are not accounted for on the balance sheet. This led to high Price/Book ratios, and Microsoft was further singled out because of their historic consistency in meeting or beating analysts expectations and their ability to generate such high returns on equity. 2. By choosing not to capitalize software development costs, Microsoft reported lower intangible assets, higher expenses, and lower net income, than if they had capitalized them according to the GAAP rules in place at the time. a. To estimate the net benefit to Microsoft, we assumed that 60% of R&D expenses in 1997, 1998, and 1999 would be capitalized and amortized using 2-year straight-line depreciation. Costs capitalized in 1997 would be expensed for .5 years in 1997, 1 year in 1998, and .5 years in 1999.

b. 1997 1863 1998 2601 $ 1,560.60 1999 2970 $ 1,782.00 Year 1 Year 2 Year 3 25% 50% 25%

R&D

$ 60% 1,117.80 Amortization Schedule 1997 R&D $279.45 558.90 279.45

1998 R&D $390.15 780.30 390.15 $ 1,560.60

1999 R&D

1997 1998 1999 2000 2001 Total

$445.50 891.00 445.50 $ 1,782.00

R&D Expense if Software Capitalized $1,024.65 1,989.45 2,693.25

R&D Expense Increase Under Current in Net System Income $1,863.00 $838.35 2,601.00 611.55 2,970.00 276.75

$ 1,117.80

The increase in net income reflected on the income statement is matched by an accompanying increase in intangible assets that is reported on the balance sheet. c. Microsoft probably chose this method of accounting for software costs to be consistent with their overall conservative approach to accounting. Microsoft did nearly everything they could to suppress net income as long as they would continue to hit their earnings estimates from Wall Street. By treating their software costs this way, they have a substantial amount of flexibility moving forward. If at any point in the future they have an issue meeting an earnings target, they can adjust their accounting practices and begin capitalizing software costs. This will shift large expenses into the future, boosting current quarter/year EPS numbers to expected levels. 3. Microsofts decision to defer revenue recognition on their two largest products (Windows and Office) reduced net income in the current period and added a substantial Unearned Revenue liability to the balance sheet. This liability was then debited out and revenue credited over the lifecycle of the product.

a. Actual Revenue 1997 $11,936.00 1998 15,262.00 1999 19,747.00 Unearned Revenues $1,601.00 3,268.00 5,877.00 Unearned Revenues Earned $743.00 1,798.00 4,526.00

Estimated Revenue $12,794.00 16,732.00 21,098.00

b. The reasons to defer revenue are very similar to their reasons to accelerate expenses. This policy enables them to suppress the current period Net Income, giving them a lot of flexibility going forward. Because Microsoft felt confident in its ability to reach analysts expectations, they moved revenue into the future and expenses into the present. 4. The overall impact of these two policies moved net income, and correspondingly earnings per share, in a negative direction. The revenue policy created a large unearned revenue liability, and the expensing of R&D rather than capitalizing reduced the reported assets Microsoft would have on the balance sheet. 5. Microsoft provided analysts with information that was intentionally overly pessimistic. According to the case, analysts referred to the annual meeting as a doom and gloom session. Additionally, when told that they had scared the hell out of people, then CEO Bill Gates engaged in a standard American celebratory ritual, giving his sales chief (and current CEO) Steve Ballmer a high-five. By creating an artificial air of pessimism surrounding the company, the analysts consensus earnings numbers will be lower, therefore creating a target that is far more attainable for the company to reach. As weve discussed in class, hitting analysts targets is a very important (perhaps the most important) job duty of the executive team. By creating a lower EPS estimate, Microsoft was able to defer revenues and expedite expenses while still meeting expectations. This created a large amount of financial flexibility for Microsoft in the future. If times ever not as rosy, they could make some quick, and perfectly legal, accounting switches which would allow them to comfortably meet the EPS numbers put out by the street. 6. Microsofts overall financial reporting strategy was extremely conservative. The company saw the great value in continuing to meet or slightly exceed the Streets expectations. The reporting department, therefore, attempted to depress the earnings numbers to match the expectations of the analysts while staying within the letter of the law.

The two practices examined in this case seem to be perfectly within the law as laid out by GAAP, but the SEC was still interested in investigating. The SEC has a duty to insure that all companies are fairly represented in all material aspects. Normally that means focusing on companies who are too aggressive with their accounting approach, but it is also possible to err too far on the side of conservatism and suppressed earnings. Based on the data available in this case, our team concluded that Microsofts financial statements fairly and accurately represented the current financial status of the corporation.