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M9.1. Analysis of the Equity Statement, Hidden Losses, and
Off-Balance-Sheet Liabilities: Microsoft Corporation
This case requires the student to reformulate and analyze Microsoft’s equity statement and then deal with the question of omitted (hidden) expenses. The accounting for these expenses (or lack of it) leads to distortions. The student discovers that many of Microsoft’s costs of acquiring expertise are not reported under GAAP. The student also understands that there are omitted liabilities for these costs and is introduced to the notion of contingent liabilities and the option overhang. The case is a little old (200) but as the advantage of covering most os the issues that arise with the statement of shareholders’ equity. Note that the accounting is not Microsoft’s fault: They are accounting according to GAAP. The Reformulated Statement of Shareholders’ Equity To get things going, reformulate the equity statement as is, without the consideration of hidden dirty-surplus items:
MICROSOFT CORPORATION
Reformulated Equity Statement: Before Dealing with Hidden Losses! Nine months ended, March 31, 2000
Balance, beginning of period $27, Transactions with Shareholders Share issuesShare repurchases $2,8434,872 (2,029) Tax benefit of shares issues for options 4, Comprehensive Income Net income $7, Unrealized investment gains 2, Translations gains 166 Preferred dividends (13) 9, Balance, end of period $39,
Notes: Tax benefits from options are in a limbo line here. Microsoft treats these as paid- in capital --- as if the tax savings are cash raised from the share issue. But see later for the treatment of these tax benefits as a reduction in the before-tax stock option compensation expense. Put warrants have been taken out of the statement because they are a liability. See the answer to Question C below. Accordingly, the closing balance of shareholders’ equity has been restated. Answering the Questions A. Net cash paid to shareholders = $2,029 million B. Comprehensive income = $9,889million. But this is the reported comprehensive income before hidden expenses. See later. C. Put warrants and other agreements to put shares to the corporations (put options and forward share purchase agreements) are options sold to banks and private investors that gives them a right to have shares repurchased by the firm at a
against future settlement in stock but with the loan off balance sheet. See Exercise E9.13 on Household International. D. When options are exercised, GAAP records the consequent share repurchase for the amount of cash paid, with no loss recognized. However, the amount paid for the shares is greater than their current market price (otherwise the warrant holder would not have exercised), so the firm repurchases at a loss. See the Dell example in the chapter. The appropriate clean-surplus accounting records the share repurchase at market value and the difference between cash paid and market value as a loss on exercise of warrants (and part of comprehensive income). See Box 9.3. E. No, repurchases do not reverse dilution. They give the appearance of reversing dilution if the number of shares repurchased equals the number issued in the exercise of options, leaving shares outstanding unchanged. But issuing shares at less than market price results in dilution of the current shareholder’s value. Repurchasing them at market price has no effect of shareholder value in an efficient market, so cannot recover the value lost. In Microsoft’s case, the firm was repurchasing stock in 2000 at bubble prices. So they were actually furthering the dilution, for buying back shares at greater than fair value loses values for the current shareholders. They were well advised to stop the repurchases. F. The loss is the difference between market price and exercise price, net of the tax benefit from deducting this difference on the tax return. As the tax rate is known and the tax benefit is reported, Method 1 in the chapter can be applied:
Stock option expense $4,002/0.375 $10, Tax benefit 4, After-tax stock option expense $6, This expense could have been entered in the reformulated equity statement, as follows:
Balance, beginning of period $27, Transactions with Shareholders Share issuesShare repurchases (2,843 +10,672) $13,5154,872 8,
Comprehensive Income Net income $7, Unrealized investment gains 2, Translations gains 166 Preferred dividends (13) Loss on exercise of stock options (6,670) 3, Balance, end of period $39,
The share issue is recorded here at market value (issue price plus the difference between issue price and market price), and the loss is recorded as part of comprehensive income. The appropriate journal entry is: Cash Dr. 2, Loss on exercise of stock optionsCommon stock and paid in capital Cr. Dr. 10,672 13, Microsoft is paying its engineers and managers with options and the appropriate accounting recognizes the (large) cost. There is quite a change to comprehensive income here.
NetStock recognized option income gains taxon investmentsbenefits (1,078)4,002 1,271(943) DeferredUnearned incomerevenue taxes 4,278 449 1,3575, RecognitionAccounts receivable of unearned revenue from prior periods (4,058)(558) (4,652)(281) OtherOther currentlong-term assets assets (328)(654) (557)(228) ---------------------------------------------------------------------------------Other^ current^ liabilities^ (1,272)^107 ---------------------------------------------------------------------------------Net^ cash^ from^ operations^ 8,738^ 9,
Notice that, for the nine months in 2000 (on which the case is based), the $4, million in tax benefits (reclassified in 2001) was 45.8% of cash from operations. Fast forward to 2005: From that year, the FASB returned to the old rule – report these tax benefits as part of financing activities. H. The total tax reported was $3,612 million on income in the income statement minus $4,002 million in tax benefits from stock options. That is, taxes were negative. The amount of $3,612 in the income statement results from allocating the taxes between the income statement and the equity statement. So, yes, Microsoft did not pay taxes the income in the incomes statement, but that is appropriate for they did have a legitimate expense for wages paid through issuing shares to employees at less than market price. If Microsoft had recognized the compensation expense in the income statement, along with the tax benefit, the income statement would have looked as follows: Income reported, before tax $10,624 million Loss on exercise of stock options 10, Loss before tax (48) Taxes ($3,612 – 4,002) (390) Net income $ 342 The negative income before tax draws a negative tax, as is usual (with the loss carried forward or back against income).
Note just one point, however. Taxes are allocated to income in other comprehensive income, so the unrealized investment gains of $2,724 million and translation gains of $166 million are after tax. So, on this income Microsoft pays taxes, recognized now as deferred taxes to be paid when the income enters its tax return. About quality of income: if a firm is paying low taxes on a high income, it must be either (1) the firm is getting certain tax credits (for R&D, for example), or (2), it is recognizing expenses for taxes that it is not recognizing on its books (or recognizing revenue in its books that is not recognized for taxes). If the difference is for reason (2), there is a concern about the quality of its accounting earnings: Is the firm recognizing the correct revenues and expenses? I. Here are the concerns arising from the Stockholders’ Equity footnote: a. Share repurchases: Is the firm purchasing its own shares at the appropriate price? b. Put warrants: there is a potential liability here because the put options might go into the money, requiring the firm to repurchase shares at more than the market price. As the strike prices ranged from $69 to $78 per share and the stock was trading at $90 at the time, the options were out of the money. However, some of the expiration dates were up to December 2002 by which time the stock had dropped to $56, so some options were subsequently exercised. When exercised, GAAP did not require Microsoft to record a loss. Not did it require the firm to book a contingent liability as these options went into the money. See Box 9.3 for the correct accounting.
Shares Wtd-ave Market Per share Total (millions) Exercise Price Price Difference Difference 133 4.57 90.00 85.43 11, 104 10.89 90.00 79.11 8, 135 14.99 90.00 75.01 10, 96 32.08 90.00 57.92 5, 198 63.19 90.00 26.81 5, 166 89.91 90.00 0.09 15 832 40,
Microsoft can deduct the amount in its tax return. So the after-tax liability is $40,598 x 0.625 = $23,374 billion
The total amount of $40.599 billion does not include option value (the calculation here is sometimes referred to as the “intrinsic value method”). However, although a floor on the valuation, it is large! Indeed, more than the total book value of shareholders’ equity. The Borrowing in 2010 With $36.8 million in “cash” (financial assets) on its balance sheet, Microsoft had no need to borrow. With no obvious investments that required cash, why was it borrowing? Borrowing at fair value does not add value, but thereinlies the clue: Interest rates at the time were at a record low―Microsoft borrowed, mostly long-term, at interest rates well below 1% (less after- tax, of course). If the firm thought it might need to borrow in the future when interest rates were likely to be higher, it might see this an opportunity. In effect, it sees borrowing as “cheap,” that is, not a fairvalue. The prospect of stock repurchases also gives a clue. Stock repurchases at fair value do not add value, but Microsoft may have considered its stock (at an
almost all-time low at the time of $24) to be cheap. Borrowing (cheaply) and repurchasing (cheaply) can be seen as a pure arbitrage play: Issue debt cheaply and use the proceeds to buy cheap stock. The 5.3% increase in themarket price on the announcement probably recognizes this.
Here are the financial statements for the case if need for presentation:
