Following the release of Windows 95 in the first quarter of the 1996 fiscal year, Microsoft adjusted its revenue recognition policy. The official reason for the change was a change in the implied commitments underlying the sale of some of the company’s software.What effect did Microsoft’s change in revenue recognition policy have on its financial statements prepared for the fiscal years 1997, 1998 and 1999? Ignore any potential tax effects.
Microsoft has adopted a policy to defer its revenues that are related to future services of the software that is sold in the current years. It has adopted an accounting policy to match the revenues with its related costs; it has underlined to defer the revenues of Windows 95 for the future services that a company is underlain to provide its customers. The services are additional updates on windows, browser and many other additional products that are under the contractual arrangement of a Windows 95 license.
This change in policy has reasonable basis that supports the policy as it is in accordance with the matching concept and ignores any cutoff error that gives misstated Financials to its stakeholders.
This change has largely affected the financial statements that reduces the revenue recognition and also affects the profitability of the firm.The revenues and profits of Microsoft have declined due to the adjustment of revenue recognition. The deferred revenues have decreased the revenues and profits with the same amount as deferred revenue.The profitability and revenues in 1997, 1998, and 1999 have declined in the amount of $858, 1,470 and 1,351 respectively (Appendix 2).
The balance sheet is also affected due to the adaptation of the new accounting policy on revenue recognition. With this change in policy, Microsoft has shown a liability that accumulates the total unearned revenue for the past and current year.
If the policy had not been adopted by Microsoft then the amount of unearned revenues had to be recorded as profit in the retained earnings. The retained earnings are dramatically affected in billion dollars due to adaptation of the new accounting policy.
Based on the discussion of Microsoft’s software capitalization policy in seminar 5 and your answer to Question 1 (a) above, describe Microsoft’s overall financial reporting strategy. In your opinion, why had the company adopted this strategy? Explain.
According to the seminar and the articles related to software capitalization, the policy has many rules that need to be followed. The policy is in favor of the stakeholders as they can have a clear picture of standing of the organization. The policy has also created some mismatch in revenue and costs related to that year.
The research and development cost related to any internally generated or purchase software must be expensed as it is incurred(Accounting for computer software costs). The only condition for capitalization is the establishment of technological feasibility.The company can capitalize its internally generated software with a view to use, sell or lease it(Software research and development costs in US and EU.).There is a mismatch to record expense in this year as the benefits from the software can flow to the entity in the future but its costs are recognized in the current period. The mismatch is created due to the recording of this extensive expense of research and development.
Microsoft’s Financial Reporting Strategy Case Solution
Microsoft has expensed all the cost related to research and development without going for any detailed research on feasibility of its research and development of software that are under consideration for the future launch. The technological feasibility is met when it has completed its planning, designing, coding and testing of the software (Accounting for computer software costs). Microsoft has not capitalized its internally generated software therefore it may not apply the appropriate application of the standard.
According to its revenue recognition policy of question number one, it used to recognize revenue at 80% for the amount receipt from customer to sell of the Windows 95 operating system. It was under the assumption that the software cost for current year is 80% that is related to Windows and 20% more cost is associated with windows that it has to bear in future years. It recorded its revenue in such manner since 1996 and resulted in millions of dollars deferred revenues that declined profits and revenues dramatically.
This assumption is appropriate somehow because it is going towards the matching concept as to match the revenues towards its related costs in the same year. The costs of further development in software are to hit the financials in future period and the revenues should be shown in the year when the cost is going to hit.3.....................................
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