Case Scenario:
Microsoft develops, manufactures, licenses, sells, and supports a wide range of software products, including operating systems for personal computers (PGs) and servers; server applications for client/server environments; business and consumer productivity applications; software development tools; and Internet and intranet software and technologies. The company has expanded its interactive content efforts, including NSN (the Microsoft Network online service), various Internet-based services, and entertainment and information software programs. Microsoft also sells PC books and input devices, and it researches and develops advanced technologies for the future software products. The following excerpt is from and article that appeared in the Wall Street Journal
MICROSOFT’S EARNINGS GROWTH SLOWED IN THE LATEST QUARTER
Microsoft Corp’s growth juggernaut slowed in its fiscal fourth quarter, but the numbers masked a surprisingly potent performance by the software giant.
The Redmond, Wash., company’s earnings barley topped Wall Streets consensuses, breaking a pattern of dramatic upside surprises for the company. But the company’s profit would have been considerably higher had it not salted away revenue in a special reserve account for use in future quarters. The account, dubbed “unearned revenues,” continued to swell and underscore the returns Microsoft is reaping as a near – monopoly supplier of personal computer operating software and key application programs. The account represents revenues Microsoft has collected but hadn’t yet reported. It was established because the company faces future cost to deliver up grades and customer support for products that already have been paid for. The policy helps smooth out sharp swings in the company’s quarterly results.
Microsoft reported net income of $1.06 billion , or 80 cents a share, for the quarter ended June 30, an increase of 89% from $559 million, or 43 cents a share, a year earlier. Analysts had expected per – share earnings of about 79 cents, according to First Call Corp. Quarterly revenue was 3.18 billion, up 41% from 2.26 billion a year earlier.
Other Information:
1. Appearing in the accompany tables are a comparative income statement for the forth quarters of fiscal 19996 and 1997 and for fiscal years 1996 and 1997. Also shown are comparative balance sheets for fiscal 1996 and 1997.
2. The balance in unearned revenues account on March 31,1997 (the end of the third fiscal quarter of 1997) was $1,285 (in millions).
3. The following description of Microsoft’s revenue unearned revenues account is taken from the company’s SEC filings:
The portion of the company’s revenues that are earned later than billed is reflected in the unearned revenues account. Of the March 31, 1997 balance of $1,285 million, approximately $765 million represented the unearned portion of Windows desktop operating systems revenues and $150 million represented the unearned portion of Office 97 revenues. Unearned revenues associated with upgrade rights for Microsoft Office 97 were $109 million and the balance of unearned revenues was primarily attributable to maintenance and other subscription contracts.
Microsoft Corporation
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Income Statement
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Three Months Ended
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Years Ended
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($ in Millions, except earnings per share)
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30-Jun
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30-Jun
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1996
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1997
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1996
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1997
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Net Revenues
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$2,255
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$3,175
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$8,671
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$11,358
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Cost of Revenues
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$241
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$242
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$1,188
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$1,085
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Research and development
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$453
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$516
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$1,432
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$1,925
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Sales and Marketing
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$661
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$744
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$2,657
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$2,856
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General and administrative
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$90
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$94
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$316
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$362
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Total operating expenses
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$1,445
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$1,596
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$5,593
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$6,228
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Operating income
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$810
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$1,597
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$3,078
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$5,130
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Interest income
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$92
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$127
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$320
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$443
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Other expenses
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($42)
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($80)
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($19)
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($259)
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Income before income takes
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$860
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$1,626
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$3,379
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$5,314
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Provisions for income taxes
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$301
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$569
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$1,184
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$1,860
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Net Income
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$559
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$1,057
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$2,195
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$3,454
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Preferred stock Dividends
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$0
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$7
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$0
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$15
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Net income available for common share holders
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$559
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$1,050
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$2,195
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$3,439
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Earnings per share
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$0.43
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$0.80
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$1.71
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$2.63
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Average shares outstanding
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$1,290
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$1,327
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$1,281
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$1,312
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Balance Sheets
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($ in Millions)
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June 30, 1996
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June 30, 1996
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Assets
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Current Assets
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Cash and short term investments
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$6,940
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$8,966
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Accounts receivables
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$639
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$980
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Other
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$260
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$427
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Total Current Assets
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$7,839
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$10,373
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Property, Plant and Equipment
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$1,326
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$1,465
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Equity Investments
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$675
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$2,346
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Other assets
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$253
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$203
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Total Assets
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$10,093
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$14,387
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Liabilities and Stockholders' Equity
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Current Liabilities
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Accounts Payable
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$808
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$721
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Accrued compensation
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$202
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$336
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Income taxes payable
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$484
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$466
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Unearned revenues
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$560
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$1,414
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Other assets
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$371
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$669
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Total current liabilities
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$2,425
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$3,610
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Minority Interest
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$125
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---
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Put Warrants
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$635
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---
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Stockholder Equity
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Convertible preferred stock
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---
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$980
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Common stock and paid capital
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$2,924
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$4,509
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Retained Earnings
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$3,984
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$5,288
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Total stockholders equity
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$6,908
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$10,777
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Total liabilities and stockholder equity
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$10,093
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$14,387
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Answer the following questions based on the available information.
Question 1. Calculate Microsoft’s net profit margin for the fourth quarter of 1996 and 1997and for the fiscal years 1996 and 1997. Comment on the results.
Question 2. Calculate Microsoft’s working capital and current ratio. Comment on the results.
Question 3. Did Microsoft fall short of, meet, or exceed analysts expectations for fourth-quarter 1997 EPS?
Question 4. If no reductions were made from the “Unearned revenues” account during the fourth quarter of fiscal 1997, how much did Microsoft add to the account during the quarter?
Question 5. Continuing requirement 4 how much higher or lower would Microsoft’s fourth-quarter income before tax have been (on a per share basis) if this accrual adjustment had not been made?
Question 6. Assume that Microsoft reduced its “Unearned revenues” account by $188.0 million during the first three quarters of fiscal 1997. How much did Microsoft add to the account during the fiscal year?
Question 7. Continuing requirement 6, how much higher or lower would Microsoft’s annual income before tax have been (on a per share basis) if this accrual adjustment had not been made?
Question 8. How much income before tax (on a per share basis) does Microsoft have “stored” in the “Unearned revenues” account at the end of 1997?
Question 9. How can the “Unearned revenues” account be used to manage EPS?
Question 10. How can analysts monitor the extent to which the “Unearned revenues” account is being used to manage EPS?
Question 11. Does the existence of the “Unearned revenues” account necessarily mean that Microsoft intends to manage its reported earnings? Explain.