Question

Using the below chart,

1. Assume that Microsoft incurred 60% of its research and development expenses after it had established technological feasibility. The average product life was two years, and the company begins amortizing software costs at the beginning of the following year. For 1997, 1998 and 1999, estimate the related impacts on operating expense and capitalized R&D costs. Ignore any tax effects.

2. Estimate the amount of revenue that Microsoft would have reported in each quarter from 1996 through 1999 if the company had not adopted its new revenue recognition policy in 1996. Ignore any potential tax effects.

3. How did these two policies impact Microsoft’s fiscal 1997, 1998, and 1999 operating income and balance sheet? Ignore any tax effects.

Exhibit 2 Microsoft Corp., 1986-1998 Annual Income Statements ($'s in millions) 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 $1,847 $2,777 $3,786 $4,714 $6,075 $9,050 $11,936 $15,262 $19,747| 410 235 581 352 785 470 1,077 610 1,346 860 2,145 1,326 2.170 1,863 2,814 2,970 490 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 2,460 2,601 296 2,828 433 230 $8,848 3,231 689 115 $9,819 Revenue $140 $198 $346 $591 $805 $1,186 Operating Expenses: Cost of revenue 30 41 78 158 220 273 Research and development 17 21 38 70 110 181 0 Acquired in-process technology 1 Sales and marketing 43 57 81 152 205 300 2 General and administrative 9 18 22 24 28 39 3 Other expenses 0 0 14 14 10 14 4 Total Operating Expenses $99 $137 $233 $418 $573 $807 5 6 Operating income $41 $61 $113 $173 $232 $379 7 Investment income 2 5 8 11 19 31 8 Noncontinuing items -- 0 0 0 0 0 9 Income before income taxes 43 66 121 184 251 410 0 Provision for taxes 19 27 49 60 80 131 1 Net income $24 $39 $72 $124 $171 $279 2 3 Source: Microsoft Corp. Financial History Pivot Table, available at http://www.microsoft.com/msft/history.htm 4 $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

Answer 1

R&D recognized on the I/S 1995 860 1996 1.326 1997 1.863 1998 2.601 1999 2.970 516 258 796 These are the adjustments to capitalize 60% of the R&D expense every year and to amortize it with SL in 2 years 0 398 1,118 0 559 1,561 0 780 1,782 2,562 Capitalized Development Costs EB 516 1,054 1,516 2,120 Amortization expense 656 957 1,339 Development costs expensed (60% of R&D) 1,118 1,561 1,782 Reduction in profit b/c of expensing Develop. -462 -604 -443 As a % of reported profit before taxes -8.70% -8.50% -3.70%

Reported revenue Change Adjusted revenue % increase Unearned revenue (L) EB 1995 0 EB 1996 560 EB 1997 1,418 EB 1998 2,888 EB 1999 4,239 560 858 1,470 1,351 9,050 11,936 15,262 19,747 9,610 12,794 16,732 21,098 6.2% 7.2% 9.6% 6.8%