Finance analysis

Microsoft has undoubtedly been the most success ful software firm ever. Between 1994 and2000, the firm’s revenues increased from $2.8 bil l ion to $23.0 billion, and its earnings from $708 million to $9.4 billion. Over the two year period from 1998 to 2000, its stock price in-creased from $36 per share to almost $120, givin .g it a trailing P/E ratio of 66 and a marketcapitalization at the height of the stock market bubble of over half a trillion dollars. By 2005, Microsoft was trading at $40 per share (on a pre-split basis) with a market capital-ization of $275 billion and a trailing P/E ratio o:f 25.

Microsoft’s success has been due to a strong p r oduct, market positioning, and innovative research and marketing. In terms of the buzzwo rds of the time, Microsoft has significant “knowledgecapital”combinedwithdominantma rketpositioningandnetworkexternalities.These intangible assets are not on its balance shee t, and accordingly the price-to-book ratio was over 12 in2000. Yet, to develop andmaintain t h e knowledge base, Microsoft had to attractleading technical experts with attractive stock option packages, with consequent costs to shareholders. Unfortunately, GAAP accounting did not report this cost ofacquiring knowl-edge, nor did it report significant off-balance-s heet liabilities to pay for the knowledge. Knowledge liabilities, as well as knowledge asset s , were missing from the balance sheet.

This case asks you to uncover the knowledge costs and the associated liabilities and todeal with other imperfections in the statement o f shareholders’ equity.

Microsoft’s income statement for the first nin e months of its June 30, 2000, fiscal year follows, along with its statement of shareholders ‘ equity at the end of the nine months and the shareholders’ equity footnote. At the time, Microsoft’s shares were trading at $90 each.Reformulate the equity statement and then answ er the questions that follow.


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