Microsoft Case Study Analysis PDF

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Harvard Business School

9-100-027 Rev. February 16, 2000

Microsoft's Financial Reporting Strategy We are a company known for being conservative. —Greg Maffei, CFO1

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.2

Company Background3 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

1 “Microsoft Faces Investigation By SEC Over Its Accounting,” Wall Street Journal, July 1, 1999. 2 Ibid. 3 This brief historical account of Microsoft’s development borrows from “Microsoft, 1995 (Abridged),” Harvard case number 9-799-003, by Professors Tarun Khanna and David Yoffie.

Professor Dawn Matsumoto and Professor Robert Bowen of the University of Washington prepared this case from public sources as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright © 1999 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School. 1 This document is authorized for use only in Dr. Narender Vunyale's Financial Accounting Trim 1 at Narsee Monjee Institute of Management Studies (NMIMS) from Jun 2021 to Dec 2021

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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. The flexibility in GAAP is provided to allow managers to better represent the economic substance of a given transaction. For software developers, there were at least two key areas in which the standards at the time allowed flexibility—software development costs and revenue recognition. In both these areas, Microsoft chose a rather conservative method of reporting.

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 mis-matching 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).

4 J. Fox, “Learn to Play the Earnings Game (And Wall Street Will Love You),” Fortune, March 31,1997. 5 Financial Accounting Standards Board, Original Pronouncements, 1998/99 Edition, John Wiley & Sons, New

York, NY, page 816. 2 This document is authorized for use only in Dr. Narender Vunyale's Financial Accounting Trim 1 at Narsee Monjee Institute of Management Studies (NMIMS) from Jun 2021 to Dec 2021

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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).

Revenue Recognition Prior to 1996, Microsoft’s revenue recognition policy was fairly straightforward. Revenues from sales to distributors and resellers were recognized when shipped, revenues from corporate license programs were recognized when the users installed the product, and revenues from products sold to OEMs (original equipment manufacturers) were recognized when the OEM shipped the licensed products. However, following the release of Windows 95 in the first quarter of fiscal 1996, the company adjusted its revenue recognition policy due to a change in the implied commitments underlying the sale of some of the company’s software.6 The following disclosure from the company’s 1997 10-K describes the change to a more conservative policy that defers revenues from selected product sales: In fiscal 1996, Microsoft committed to integrating its Internet technologies, such as the Company's Internet browser, Microsoft Internet Explorer, into existing products at no additional cost to its customers. Given this strategy and other support commitments such as telephone support, Internet-based technical support, and unspecified product enhancements, Microsoft recognizes approximately 20% of Windows operating systems revenue over the product life cycles, currently estimated at two years. The unearned portion of revenue from Windows operating systems was $425 million and $860 million at June 30, 1996 and 1997. Since Office 97 is also tightly integrated with the rapidly evolving Internet, and subsequent delivery of new Internet technologies, enhancements, and other support is likely to be more than minimal, a ratable revenue recognition policy became effective for Office 97 licenses beginning in 1997. Approximately 20% of Office 97 revenue is recognized ratably over the estimated 18-month product life cycle. Unearned revenue associated with Office 97 totaled $300 million at June 30, 1997. At the time that the company made this change, GAAP did not directly address the recognition of software revenues. Greg Maffei, CFO of Microsoft, explained the company’s decision during an analyst’ meeting in 1997: We ship a product, the customer gets the benefit of many of the fine features of that product the day we ship. But there are subsequent deliverables: browsers, product support, subsequent upgrades that are flying upgrades which are free or which do not require incremental payment, or potentially—God forbid—bug fixes. Per GAAP, as GAAP requires, we put the value of those subsequent upgrades, what are called unspecified enhancements, we try and put a value on those things. And as

6 Microsoft’s current fiscal year-end is June 30. Therefore, the first quarter of fiscal 1996 ended on September 30,

1995 (and Windows 95 was released in August 1995). 3 This document is authorized for use only in Dr. Narender Vunyale's Financial Accounting Trim 1 at Narsee Monjee Institute of Management Studies (NMIMS) from Jun 2021 to Dec 2021

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we subsequently ship those unspecified enhancements over the life cycle of the product, we recognize revenue. Currently, we are basically at an 80/20 recognition policy, as required and as we earn it, for these products, meaning that 80 percent of the value is delivered day one and 20 percent over the remaining life cycle of the product.”7 The balance in the company’s unearned revenue account grew steadily following the adoption of the new revenue recognition policy in 1996 (see Exhibits 3, 4, and 6). By the end of fiscal 1999, the ending balance in the unearned revenue account was $4.2 billion—approximately a full quarter’s worth of revenue. The balance was large enough that Wall Street analysts paid close attention to the number. In a 1999 analyst report, Morgan Stanley Dean Witter analyst Mary Meeker noted, “We believe the company’s core earnings power is held back, in part, by the company’s aggressive revenue-deferral efforts.”8 While specific guidance on the treatment of software revenues did not exist in 1995, the American Institute of Certified Public Accountants (AICPA) subsequently issued Statement of Position (SOP) 97-2 that directly addressed the recognition of revenue related to upgrades, add-ons, and other enhancements. The statement required that a portion of software revenue be deferred when the software arrangement consisted of “ multiple elements,” including additional software products, upgrades/enhancements, and postcontract customer support, even if the elements were deliverable only on a “when and if available basis.”9 Microsoft apparently viewed the integration of its Internet browser as an additional “element” to which a portion of the current revenue received from its sales of Windows and Office 97 had to be attributed. 10

Managing Analysts’ Expectations 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.11 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.12 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

7 Taken from transcripts of Greg Maffei’s address to analysts on July 24, 1997, obtained in July 1999 from

http://www.microsoft.com/PressPass/exec/greg/finsummit97.html. 8 R. Fink, “Smooth Operator,” CFO Magazine, August 1999. 9 AICPA, Statement of Position 97-2, Software Revenue Recognition, October 27, 1997, page 7. 10 In response to the AICPA Statement of Policy (SOP) 98-9, in the fourth quarter of fiscal 1999 Microsoft changed its model for deferring revenues. The percentage of revenue deferred was decreased for both operating systems (e.g., Windows NT) and for desktop applications (e.g., Office), the effect of which was to increase reported revenue. In addition, the estimated product life cycle for operating systems was extended from two to three year, which served to decrease reported revenue. The estimated product life cycle for desktop applications was left unchanged at 18 months. 11 M. Flores, “Company Execs Meet with Top Stock Analysts,” Seattle Times, July 23, 1997. 12 J. Fox, “Learn to Play the Earnings Game (And Wall Street Will Love You),” Fortune, March 31,1997. 4 This document is authorized for use only in Dr. Narender Vunyale's Financial Accounting Trim 1 at Narsee Monjee Institute of Management Studies (NMIMS) from Jun 2021 to Dec 2021

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was at least one reason the company maintained such large balances in its cash and short-term investment accounts (see Exhibits 3 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.13 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.”14 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. . . .”15 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.”16 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.

The SEC Investigation In a 1998 speech at New York University, SEC Chairman Arthur Levitt discussed what he perceived as a growing problem with financial reporting: 17 Increasingly, I have become concerned that the motivation to meet Wall Street earnings expectations may be overriding common sense business practices. Too many corporate 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.

13 B. Schlender, “The Bill & Warren Show,” Fortune Magazine, July 20, 1998. 14 D. Stauffer, “What You Can Learn about Managing from Microsoft,” Harvard Management Update, article

reprint no. U9709A, 1997. 15 J. Wallace, and J. Erickson, Hard Drive: Bill Gates and the Making of Microsoft, John Wiley & Sons, New York, NY, 1992, page 419. 16 J. McCafferty, “Speaking of Earning. . . ”CFO Magazine, October 1997. 17 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. 5 This document is authorized for use only in Dr. Narender Vunyale's Financial Accounting Trim 1 at Narsee Monjee Institute of Management Studies (NMIMS) from Jun 2021 to Dec 2021

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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 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.”18 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 fa...