Question: Some savvy investors detecting fissures in Microsoft s armor are pulling

Some savvy investors, detecting fissures in Microsoft’s armor, are pulling back from the world’s most highly valued company. The concern: the first-ever drop in an arcane but closely watched indicator of Microsoft’s future results.
The balance in Microsoft’s “unearned revenue” account, which declined to $4.13 billion on Sept. 30 from $4.24 billion in June, has become a lightning rod for more general concerns about the price of the company’s shares. . . . Managers of several large funds . . . are shedding part of their Microsoft holdings. The immediate trigger was the first quarter-to-quarter decline in Microsoft’s unearned revenue account. . . .
In the software industry, Microsoft pioneered the practice of recording a portion of the revenue from some products as “unearned,” starting with the release of Windows 95. The practice is common in some other fields: Many magazine publishers, for instance, record subscription revenues only when issues are shipped.
Similarly, Microsoft now holds back a portion of revenues from Windows 98, Windows NT and Office until it “earns” the revenue by delivering interim upgrades, bug fixes and other customer support. The account also includes the value of coupons that customers receive, which entitle them to free upgrades when they buy a Microsoft product before the next version is ready. A delay in the shipment of Office 2000 earlier this year caused the company to add $400 million to the unearned revenue account in the March quarter to cover the coupons issued to buyers of Office 97. As copies of Office 2000 were shipped, half of that amount flowed into the June quarterly results; another $150 million was transferred in the fiscal quarter ended in September.
The effect was to bolster earned revenues in those quarters and lower unearned revenues. . . .

1. Based on the revenue recognition principles discussed in Chapters 2 and 3, explain why a company such as Microsoft would set aside some software sales revenues as “unearned”?
2. How would you determine how much sales revenue to set aside each quarter? Is this number easy to calculate?
3. Suppose the Unearned revenue account is reduced by $100 million. Where do these dollars go? (The Unearned revenue account is reduced by a debit. What account receives the offsetting credit?)
4. Describe how contracting and regulatory incentives might influence how much revenue is set aside as unearned. How might these incentives influence when the Unearned revenue account is reduced and by how much?
5. Why do analysts and investors pay such close attention to changes in Microsoft’s Unearned revenue account?

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