Case

1. Describe Microsoft's overall reporting strategy. Why had the company adopted this strategy and why was the SEC concerned about it?

Answer:

1) Hiding profits – The success of Microsoft provided incentives in hiding success from regulators and competitors. There is high incentive to reduce their performance given the history of the company with regulatory intervention. Therefore, the company’s policy of software capitalization occurred before serious regulatory intervention.

2) Avoiding complacency – This argument suggests that the company to avoid complacency should reduce its earnings performance and hence accompany financial success. The philosophy of the company of constructive paranoia about the competitive position and policy of Gates maintains cash balances are consistent with avoiding complacency. It has a better explanation because of the tendency of the company to “talk down” analysts’ expectations instead of explanation for choosing conservative policies.

3) Competitive weapon – As a leader of the industry, Microsoft has the ability to practices and influences accounting policies within the industry. As it is the strongest player in the industry, therefore it makes difficult for other companies to show good performance even by setting conditions that reduces their assets and earnings.

4) Signaling – By reporting strong earnings numbers and choosing conservative accounting policies, Microsoft is able to signal the strength of finance. Or they explain their ability to take the hit to earnings and still provides with strong results.

2. Assume that 60% of Microsoft's research and development expenses were incurred after technological feasibility was established, that the average product life was two years, and that the company begins amortizing software cost at the beginning of the following year. Estimate the effect of capitalizing software costs on Microsoft's fiscal 1997, 1998, and 1999 income statements and balance sheets.

a. Speculate as...