27 January 2008

MSFT: Footnotes to the 10-Q

Michelle Leder's "Financial Fine Print, Uncovering a Company's True Value" convinced us that we need to spend more time reading the footnotes that accompany the financial statements in 10-Q and 10-K reports. Our approach to the footnotes had simply been to harvest numerical data for use in the financial models we build for each company under analysis.

Michelle is the founder and editor of footnoted.org, which is one of our favorite web sites. We believe that the, um, large legion of GCFR fans will be interested in Michelle's book and will want to read footnoted.org daily.

We started with Microsoft's 10-Q for the quarter that ended on 31 December 2007. We had just analyzed the financial statements in this quarterly report. A company with the financial might of Microsoft has no reason to engage in obfuscation, so we figured the footnotes would be an easy read.

Right off the bat, one of Michelle's central theses is made plain. Companies have a tremendous amount of flexibility when calculating the data shown in the financial statements. The numbers are far more subjective than many people realize. Microsoft discloses this fact in the Basis of Presentation section of Note 1, when they say: "Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses." A lengthy list of examples follows.

In the Recent Accounting Pronouncements section of Note 1, we see that two changes approved by the Financial Accounting Standards Board in December 2007 won't become effective at Microsoft until July 2009 and then will be applied prospectively. The latter point presumably means the new rules will be applied to future transactions, but previous transactions won't be restated.

We also learned that Microsoft charged $395 million (about $0.04/share) last July to Retained Deficit/Earnings, which is a component of Stockholders' Equity. The charge was associated with changes in tax accounting.

In GCFR, all per-share calculations are based on the number of common shares outstanding plus the dilutive effects of additional shares that might be awarded as a result of stock options and other share-based compensation. The use of diluted earnings per share, instead of the basic EPS, has become widespread in recent years. What we didn't realize until we carefully read Note 3 was that companies can exclude certain share awards from the dilutive calculation. In Microsoft's case, the number of shares excluded are trivial, but we will be on the lookout to see whether the opposite might be true for other companies.

Footnote 4 addresses Unearned Revenue. According to accountinginfo.com, which makes clear a difficult topic, Unearned Revenue is cash received before services are provided. It is a liability because the amounts are theoretically refundable to customers if the service is not provided in the future. Microsoft's footnote doesn't disclose the nature of its Unearned Revenue, but the company is known to have arrangements with customers in which it accepts cash with the promise of providing some number of software upgrades in a defined period. Once those upgrades are delivered, the cash previously received can be recognized as Revenue.

The footnote indicates that Unearned Revenue was a $12.178 billion liability on 31 December 2007. We tried to see if there was a way to determine what percent of quarterly Revenue had previously been classified as unearned. However, since company undoubtedly took in new Unearned Revenue, we were unable to make this calculation.

It's well known that Microsoft has been actively repurchasing its shares. From Footnote 5, we see that the company spent more than $4 billion (at an average cost of $34.01) to buyback shares in last quarter. (It's easy to confuse millions and billions in this footnote. We cross-checked with earlier 10-Q's to verify the units.) Since the January declines in the stock market have reduced the price of Microsoft shares from $35.60 to $32.94, the company could decide to step up its purchases. The footnote informs us that $8.7 billion remains available under previously approved repurchase programs, which totaled $36.2 billion.

When we were looking ahead to the results of the December quarter, we stated that investment and interest income would probably decline because cash was being spent on share repurchases. We were surprised to see an increase in non-operating income, and it threw off our earnings estimate by $39 million. In Footnote 6, we see that Dividend and Interest income declined by $110 million. However, a $75 million loss in derivatives in December 2006 became a $48 million gain in December 2007. This $123 million swing explains the surprising increase in investment income.

The estimated costs of warranties for hardware and software are included as other current and non-current liabilities on Microsoft's balance sheet. These liabilities totaled $861 million on 31 December 2007, up $11 million from 30 June 2007. From previous disclosures, we expect that charges related to the Xbox game make up a substantial portion of the warranty provisions. The footnote, however, doesn't give us this visibility.

Note 8, Contingencies, describes the company's ongoing legal and regulatory challenges in the U.S. and Europe regarding its competitive practices. These matters have been well covered in the business press and elsewhere, and we didn't see anything newsworthy in the footnote. We observed that the company couldn't resist whining that complaints with regulators had been filed by a trade association of Microsoft competitors.

We hadn't realized the extent to which Microsoft and Alcatel-Lucent are entangled in legal disputes alleging patent infringements. (We knew that a $1.5 billion judgment against Microsoft was later overturned; we didn't know that this was one game in an ongoing match.) If current behaviors persist, lawyers specializing in intellectual property at both companies will be busy for many years to come.

Microsoft purchased aQuantive for $5.9 billion in cash in August 2007. Note 10 indicates that the purchase resulted in $6.2 billion worth of Goodwill and Intangible Assets. The note also indicated how the Intangible Assets (less than $1.0 billion) would be depreciated as an expense of the next few years. In Note 11, we learn that none of the $5 billion worth of Goodwill acquired is deductible.

In Note 13, Income Taxes, we had hoped we might get a better understanding of the differences between what Microsoft reports to public in conformance with Generally Accepted Accounting Principles and what Microsoft reports to the Internal Revenue Service and other tax authorities. However, we have proven unable to discern the true meaning of the following two sentences: "We have not provided deferred U.S. income taxes or foreign withholding taxes on temporary differences of approximately $9.5 billion as of December 31, 2007 and $6.1 billion as of June 30, 2007, primarily resulting from earnings for certain non-U.S. subsidiaries which are permanently reinvested outside the United States. The amount of unrecognized deferred tax liabilities associated with these temporary differences was $2.8 billion as of December 31, 2007 and $1.8 billion as of June 30, 2007."

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