. *Microsoft’s Financial Reporting Strategy 1. What are the factors that likely explain the difference between Microsoft’s market value of equity and its reported book value of equity? The most obvious reason for the difference between the market value of equity and the book value of equity is the inability to record certain intangible assets such as brand value, customer loyalty, and perhaps most importantly, human capital. These intangible assets are likely to provide tremendous earnings growth in the future which determines the company’s market value. Notice also that the company’s choice of conservative accounting policies has the effect of depressing the company’s book value of equity. 2. What effect did Microsoft’s software capitalization policy have on its financial statements? Ignore any potential tax effects. a. 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 costs 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. 1995 1996 1997 1998 1999 R&D recognized on the I/S 860 1,326 1,863 2,601 2,970 These are the adjustments to 516 258 0 capitalize 60% of the R&D expense 796 398 0 every year and to amortize it with 1,118 559 0 SL in 2 years 1,561 780 1,782 Capitalized Development Costs EB 516 1,054 1,516 2,120 2,562 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% b. Why do you think Microsoft chose to expense all software costs as incurred rather than capitalizing a portion of these costs? Remember that the FASB