Software Microsoft's Development Costs
We are a company known for being conservative. --Greg Maffei, CFO2
1
On June 30, 1999, during a conference call with analysts, Microsoft Corporation announced that the company was under investigation by the Securities and Exchange Commission (SEC) for certain accounting practices. Although the exact focus of the investigation was not disclosed, the common belief was that the investigation involved the company's deferral of revenue and other undisclosed reserve accounts.3 Company Background As the developer and manufacturer of products such as the Windows operating system, the Internet Explorer web browser, and the Microsoft Office suite of applications, Microsoft was easily the most widely recognized software developer in the world. The company's history had been well documented--in articles, books, documentaries and even a made-for-television movie, "Pirates of Silicon Valley." Bill Gates and Paul Allen founded the company in 1975, with the idea that one day there would be "a computer on every desk and in every home." The company's big break came in 1980 when it negotiated with IBM to provide the operating system for IBM's new personal computer. The result was MS-DOS and by the mid-80s, Microsoft dominated the market for operating systems. The company went public on March 13, 1986 at $25.75 per share. As of June 30, 1999, one share of Microsoft purchased at the initial public offering was worth almost $13,000. By this time, the company also had the highest market value of any U.S. public company (approximately $460 billion) and its CEO, Bill Gates, was the world's wealthiest individual. Since going public in 1986, the company's financial performance had been nothing short of extraordinary (see Exhibits 1 and 2). Revenue and operating income grew an average of 43% and 49% per year, respectively. As of June 30, 1999, the company had cash and short-term investments of $17 billion, assets totaling $37 billion and book value of equity equal to $28 billion (see Exhibit 3). Perhaps even more impressive than its astounding growth was the steady way in which the company achieved this growth. In every quarter since going public, the company's net income increased from the same quarter in the prior year and its revenue never grew less than 15%. Also, the company met or exceeded consensus analysts' forecasts of earnings in every quarter except one (back in 1988).4 This stable growth was reflected in the company's stock price (see Exhibit 5), which increased steadily from 1986 through mid-1999. Considering the relatively volatile industry in which the company operated, Microsoft's ability to consistently report higher than expected financial performance was clearly an impressive track record. Microsoft's performance was even more remarkable when considering the fact that the company was known for being relatively conservative in its accounting choices. While Generally Accepted Accounting Principles (GAAP) establish basic standards by which companies report their financial results, the standards are often sufficiently vague to allow managerial discretion in determining the appropriate accounting treatment for a given transaction. For software developers, one area in which the standards at the time were somewhat vague was in the treatment of software development costs. As with many of its financial reporting choices, Microsoft chose a rather conservative method of reporting these costs.
1 2 3 4
Adapted by Professor Dawn Matsumoto from "Microsoft's Financial Reporting Strategy" (HBS Case No. 9-100-027) written by Professors Dawn Matsumoto and Robert Bowen. May 2003 "Microsoft Faces Investigation By SEC Over Its Accounting," Wall Street Journal, July 1, 1999. Ibid. J. Fox, "Learn to Play the Earnings Game (And Wall Street Will Love You)," Fortune, March 31,1997.
Microsoft's Software Development Costs
Software Development Costs Under GAAP, accounting for software development costs must conform to Statement of Financial Accounting Standards (SFAS) No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed. The Financial Accounting Standards Board (FASB) issued the Statement in August 1985 as a response to industry concerns that treating software development costs in a similar fashion to research and development costs (i.e., expensed as incurred) led to a severe mismatching of costs and related revenue. The Statement covers both internally developed software as well as purchased software. A summary of the requirements from the Statement follows: This Statement specifies that costs incurred internally in creating a computer software product shall be charged to expense when incurred as research and development until technological feasibility has been established for the product. Technological feasibility is established upon completion of a detail program design or, in its absence, completion of a working model. Thereafter, all software production costs shall be capitalized and subsequently reported at the lower of unamortized cost or net realizable value. Capitalized costs are amortized based on current and future revenue for each product with an annual minimum equal to the straight-line amortization over the remaining estimated economic life of the product. (SFAS 86)5 The Statement defines technological feasibility to be established when "the enterprise has completed all planning, designing, coding, and testing activities that are necessary to establish that the product can be produced to meet its design specifications including functions, features, and technical performance requirements" (SFAS 86, Paragraph 3). The following excerpt from Microsoft's 1999 annual report described the company's policy on research and development costs (which includes software development costs): Research and development costs are expensed as incurred. Statement of Financial Accounting Standards (SFAS) No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed, does not materially affect the Company. During the period 1986-1999, Microsoft's annual outlays for research and development ranged anywhere from 11% to 17% of revenue (see Exhibit 2). Microsoft's conservatism Microsoft's conservative treatment of its software development costs was just one of its many conservative accounting choices. For example, the company also deferred large portions of its revenue, arguing that the revenue was unearned because of implied promises for future upgrades, bug fixes, etc. In addition to its conservative accounting choices, Microsoft was known for being conservative in discussing its expectations for future earnings. Company management consistently cautioned analysts that its phenomenal past growth was unlikely to continue--a tradition that prompted some analysts to refer to the annual analyst meeting held by the company as the "doom and gloom" session.6 Goldman Sach's analyst Rick Sherlund recalled an encounter with CEO Bill Gates and sales chief Steve Ballmer after an analyst' meeting in 1995 in which Sherlund said, "Congratulations. You guys scared the hell out of people." Gates and Ballmer responded by giving each other a high five.7 Microsoft's pessimism about its future performance could have been the result of genuine concern over the sustainability of the company's competitive advantage. After all, the company operated in an environment in which the industry leader could easily become complacent in its success and quickly lose its competitive position. The potential for sudden changes in the industry was at least one reason the company maintained such large balances in its cash and short-term investment accounts (see Exhibits 3
5 6 7
Financial Accounting Standards Board, Original Pronouncements, 1998/99 Edition, John Wiley & Sons, New York, NY, page 816. M. Flores, "Company Execs Meet with Top Stock Analysts," Seattle Times, July 23, 1997. J. Fox, "Learn to Play the Earnings Game (And Wall Street Will Love You)," Fortune, March 31,1997. 2
Microsoft's Software Development Costs
and 4). Bill Gates explained the reasoning behind the company's policy of maintaining large cash balances during a panel discussion at the University of Washington with fellow billionaire and friend, Warren Buffet: The thing that was scary to me was when I started hiring my friends, and they expected to be paid. And then we had customers that went bankrupt--customers that I counted on to come through. And so I soon came up with this incredibly conservative approach that I wanted to have enough money in the bank to pay a year's worth of payroll, even if we didn't get any payments coming in. I've been almost true to that the whole time. We have about $10 billion now, which is pretty much enough for the next year.8 Microsoft was also known to foster a sense of crisis and paranoia within the company. David Stauffer summarized one of Microsoft's key management techniques as "never stop looking over your shoulder."9 For example, in Hard Drive: Bill Gates and the Making of Microsoft, Gates stated: "Yes, our revenues are bigger than anybody else's, but if we don't run fast and do good things. . . ."10 The sentence was left unfinished but the implied message was clear--grow complacent and your leadership position will quickly evaporate. On the other hand, others argued that the pessimistic attitude was simply an attempt to manage analysts' expectations. Analysts develop expectations of future earnings using information that management provides about future prospects (often referred to as "analyst guidance"). By providing a relatively pessimistic outlook, management can lower analysts' expectations, reducing the possibility that earnings, when announced, will fall short of analysts' estimates--an outcome that could lead to a severe drop in stock price. Wendy Abramowitz, securities analyst for Argus Research Corp. noted, "A lot of companies lowball estimates. Microsoft has been doing that for a long time."11 The fact that Microsoft was able to meet or exceed analysts' expectations in 52 of 53 quarters since going public was at least partially attributable to the conservative guidance Microsoft executives provided to the financial analyst community. SEC Concerns In a 1998 speech at New York University, SEC Chairman Arthur Levitt discussed what he perceived as a growing problem with financial reporting: 12 Increasingly, I have become concerned that the motivation to meet Wall Street earnings expectations may be overriding common sense business practices. Too corporate many managers, auditors, and analysts are participants in a game of nods and winks. In the zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking may be winning the day over faithful representation. While the problem of earnings management is not new, it has swelled in a market that is unforgiving of companies that miss their estimates. Levitt went on to describe what he considered the more popular methods for managing earnings, one of which he labeled "Cookie Jar Reserves": A third illusion played by some companies is using unrealistic assumptions to estimate liabilities for such items as sales returns, loan losses, or warranty costs. In
8 9
B. Schlender, "The Bill & Warren Show," Fortune Magazine, July 20, 1998.
D. Stauffer, "What You Can Learn about Managing from Microsoft," Harvard Management Update, article reprint no. U9709A, 1997.
10 11 12
J. Wallace, and J. Erickson, Hard Drive: Bill Gates and the Making of Microsoft, John Wiley & Sons, New York, NY, 1992, page 419. J. McCafferty, "Speaking of Earning. . . "CFO Magazine, October 1997. Taken from transcripts of Arthur Levitt's speech at New York University on September 28, 1998, obtained in October 1998 from http://www.sec.gov/news/speeches/spch220.txt. 3
Microsoft's Software Development Costs
doing so, they stash accruals in cookie jars during the good times and reach into them when needed in the bad times. The SEC's investigation of Microsoft was reportedly prompted by a wrongful dismissal suit filed by the company's former head of internal auditing, Charles Pancerzewski. The suit, filed in 1997, charged that the company regularly manipulated reserve accounts to smooth reported earnings and that the auditor was dismissed after questioning the practice to the CFO (in 1997), Mike Brown. Court transcripts cited an e-mail message from Brown to Bill Gates in which the former CFO stated, "I believe we should do all we can to smooth our earnings and keep a steady state earnings model."13 The suit was settled out of court in Fall 1998; the terms of the settlement were not disclosed by mutual agreement. Microsoft was certainly no stranger to government scrutiny. The company had been the subject of investigations by the Federal Trade Commission and the Department of Justice (DOJ) from as far back as 1990. The most recent investigation and trial began in late 1997 and focused on the alleged anticompetitive effects caused by Microsoft's incorporation of its web browser, Internet Explorer, into Windows 95. The SEC investigation, however, was the first probe into Microsoft's financial reporting practices. To date, both the SEC and Microsoft have refused to comment in detail on the nature of the investigation; however, Microsoft adamantly denies engaging in any improper reporting of earnings. The announcement of the investigation apparently had little impact on Wall Street--the company's stock price rose slightly in after-hours trading following the announcement. In addition, several Wall Street analysts downplayed the importance of the investigation: If the SEC wants to force Microsoft to be less conservative, Wall Street will just increase earnings projections for the company. --Rick Sherland, Goldman Sachs analyst14 Microsoft has demonstrated a consistent history of conservative accounting. I can't at this point get too excited about this. I have a DOJ trial going on. --Bill Epifanio, J. P. Morgan analyst15
Still, some believed Microsoft was quite strategic in its financial reporting and disclosure decisions. Marshall Senk, Robertson Stephens analyst, claimed, "Microsoft does a better job of leveraging accounting--I would almost say it's a competitive weapon--than anybody else in the industry."16
13 14 15 16
"Digits: Gambits and Gadgets In the World of Technology," Wall Street Journal, January 14,1999. "Microsoft Faces Investigation By SEC Over Its Accounting," Wall Street Journal, July 1, 1999. "SEC Investigating Microsoft Practices Earnings Manipulated, Former Employee Contends," Seattle Times, July 1, 1999. J. Fox, "Learn to Play the Earnings Game (And Wall Street Will Love You)," Fortune, March 31,1997 4
Microsoft's Software Development Costs
Questions 1. What effect did Microsoft's software capitalization policy have on its financial statements? a. Consider the following "thought experiment." What if 70% of the research and development expenses reported on the company's income statement were incurred after technological feasibility was established, the average product life was two years, and the company begins amortizing software costs (using the straight-line method) at the beginning of the following year what affect would capitalizing the software costs have on Microsoft's 1997, 1998, and 1999 income statements, balance sheets, and cash flow statements? b. How reasonable are the above assumptions? c. How does Microsoft justify not capitalizing its software development costs? What assumptions are they likely making that differ from the ones made in 1a? 2. Speculate as to why Microsoft chose to expense all software costs as incurred rather than capitalizing a portion of these costs. a. What incentives might the company have for choosing to expense rather than capitalize its software development costs? b. Do any of their other choices/behaviors support your conclusion? 3. Do you agree or disagree with Microsoft's treatment of its software costs? a. Why was the SEC concerned about Microsoft's policy? b. What effect, if any, does their choice have on the information investors receive about the company?
5
Microsoft's Software Development Costs
Exhibit 1Microsoft Corp., Financial Performance since Initial Public Offering
20,000 R evenue 18,000 O perating Incom e Net Incom e
16,000
14,000
12,000 $'s in m illions
10,000
8,000
6,000
4,000
2,000
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Year
Source:
Microsoft Corp. Financial History Pivot Table, available at http://www.microsoft.com/msft/history.htm
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Exhibit 2Microsoft Corp., 19861998 Annual Income Statements ($'s in millions)
1985 Revenue Operating Expenses: Cost of revenue Research and development Acquired in-process technology Sales and marketing General and administrative Other expenses Total Operating Expenses 43 9 0 $99 30 17 $140
1986 $198
1987 $346
1988 $591
1989 $805
1990 $1,186
1991 $1,847
1992 $2,777
1993 $3,786
1994 $4,714
1995 $6,075
1996 $9,050
1997 $11,936
1998 $15,262
1999 $19,747
41 21
78 38
158 70
220 110
273 181
410 235
581 352
785 470
1,077 610
1,346 860
2,145 1,326
2,170 1,863
2,460 2,601 296
2,814 2,970
57 18 0 $137
81 22 14 $233
152 24 14 $418
205 28 10 $573
300 39 14 $ 807
490 62 16 $1,213
758 90 11 $1,792
1,086 119 7 $2,467
1,135 166 16 $3,004
1,564 267 16 $4,053
2,185 316 19 $5,991
2,411 362 259 $7,065
2,828 433 230 $8,848
3,231 689 115 $9,819
Operating income Investment income Noncontinuing items Income before income taxes Provision for taxes Net income
$ 41 2 -43 19 $ 24
$ 61 5 0 66 27 $ 39
$113 8 0 121 49 $ 72
$173 11 0 184 60 $124
$232 19 0 251 80 $171
$ 379 31 0 410 131 $ 279
$ 634 37 0 671 208 $ 463
$ 985 56 0 1,041 333 $ 708
$1,319 82 0 1,401 448 $ 953
$1,710 102 (90) 1,722 576 $1,146
$2,022 191 (46) 2,167 714 $1,453
$3,059 320 0 3,379 1,184 $2,195
$4,871 443 0 5,314 1,860 $3,454
$6,414 703 0 7,117 2,627 $4,490
$9,928 1,803 160 11,891 4,106 $7,785
Source:
Microsoft Corp. Financial History Pivot Table, available at http://www.microsoft.com/msft/history.htm
Exhibit 3Microsoft Corp., Balance Sheets for the Years Ended June 30, 1997, 1998, and 1999
1997 Current Assets: Cash and short-term investments Accounts receivable Other Total Current Assets Property and equipment Equity investments Other assets Total Assets 8,966 980 427 10,373 1,465 2,346 203 14,387
1998
1999
13,927 1,460 502 15,889 1,505 4,703 260 22,357
17,236 2,245 752 20,233 1,611 14,372 940 37,156
Liabilities and Stockholders' Equity Current Liabilities: Accounts payable Accrued compensation Income taxes payable Unearned revenue Other Total Current Liabilities Commitments and Contingencies Stockholders' Equity: Convertible preferred stock--shares authorized 100; shares issued and outstanding 13 Common stock and paid-in capital--shares authorized 8,000; shares issued and outstanding 2,408 and 2,470 Retained earnings Total Stockholders' Equity Total Liabilities and Stockholders' Equity 980 980 980 721 336 466 1,418 669 3,610 759 359 915 2,888 809 5,730 874 396 1,607 4,239 1,602 8,718
4,509 5,288 10,777 14,387
8,025 7,622 16,627 22,357
13,844 13,614 28,438 37,156
Source:
Microsoft Corp., annual report, 1999.
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Exhibit 4Microsoft Corp., Statements of Cash Flows for the Years 19971999
1997 Operations: Net Income Depreciation and amortization Write-off of acquired in-process technology Gain on sale of Softimage, Inc. Unearned revenue Recognition of unearned revenue from prior periods Other current liabilities Accounts receivable Other current assets Net cash from operations Financing: Common stock issued Common stock repurchased Put warrant proceeds Preferred stock issued Preferred stock dividends Stock option income tax benefits Net cash from (used for) financing Investments: Additions to property and equipment Cash portion of WebTV purchase price Cash proceeds from sale of Softimage, Inc. Purchase of investments Maturities of investments Sales of investments Net cash used for investment Net change in cash and equivalents Effect of exchange rates on cash and equivalents Cash and equivalents, beginning of year Cash and equivalents, end of year Short-term investments Cash and short-term investments
1998
1999
3,454 557 --1,601 (743) 321 (336) (165) 4,689
4,490 1,024 296 -3,268 (1,798) 208 (520) (88) 6,880
7,785 1,010 -(160) 5,877 (4,526) 966 (687) (235) 10,030
744 (3,101) 95 980 (15) 796 (501)
959 (2,468) 538 -(28) 1,553 554
1,350 (2,950) 766 -(28) 3,107 2,245
(499) --(18,216) 1,874 13,752 (3,089) 1,099 6 2,601 3,706 5,260 8,966
(656) (190) -(19,114) 1,890 10,798 (7,272) 162 (29) 3,706 3,839 10,088 13,927
(583) -79 (36,441) 4,674 21,080 (11,191) 1,084 52 3,839 4,975 12,261 17,236
Source:
Microsoft Corp., annual report, 1999.
9
Exhibit 5Microsoft Corp., Stock Price Performance Since Initial Public Offering
Price (split-adjusted)
100 90 80 70 60 Dollars 50 40 30 20 10 0
Mar-90 Mar-92 Mar-93 Mar-99 Mar-86 Mar-87 Mar-88 Mar-89 Mar-91 Mar-94 Mar-95 Mar-96 Mar-97 Mar-98
Month-end
Source:
Center for Research in Security Prices (CRSP).