Change in Accounting Estimate Boosts Microsoft’s Q1 2021 Gross Margin

Tech giant Microsoft [Nasdaq: MSFT] announced its first quarter 2021 results on October 27, 2020. Growth in Microsoft’s gross margin and operating income was driven by a change in accounting estimate for the useful lives of server and network equipment. The results beat analyst estimates, but guidance for revenue for Q2 2021 (between $39.5 billion to $40.4 billion) came in short of expectations, despite Microsoft’s plan to release a new gaming console during the holiday shopping season.

Microsoft’s gross margin increased in Q1 2021 to $26.15 billion – up 15% from Q1 2020 –  and operating income increased to $15.9 billion – an increase of 25% – driven by growth in all their segments, and, notably, a reduction in depreciation expenses due to the change in estimated useful lives of equipment.

The change in accounting estimate was first disclosed in their annual report, filed on July 30, 2020, becoming effective at the beginning of Microsoft’s fiscal year 2021. The estimated useful life of server equipment increased from three years to four, while the estimated useful life of network equipment increased from two years to four.

The seemingly slight change in accounting estimate to extend the depreciable life for these assets does not impact historical depreciation expenses, total depreciation expenses over the life of the asset, or cash flows; however, the change does impact the timing of depreciation expense in the future, as can be seen in Microsoft’s Q1 2021 results.

For full fiscal year 2021, Microsoft anticipates that their operating income will be positively impacted by the change by approximately $2.7 billion, or $0.09 per share. The EPS target for Q1 2021 was $1.54, $0.08 higher than Q4 2020 EPS. This means Microsoft expected all of its EPS growth in Q1 2021 to come from this change in estimate. Microsoft beat their EPS target, disclosing $1.82 diluted earnings per share for Q1 2021.

Going forward, the accounting estimate change related to depreciable life is expected to increase Microsoft’s commercial cloud gross margin by approximately four points year over year. In Q1 2021, Microsoft’s commercial cloud gross margin percentage increased 5 points to 71%. Again, this increase was driven by the change in accounting estimate. According to Microsoft, “Excluding [the impact from the change in estimated useful lives] gross margin percentage increased slightly.”

Microsoft’s change in accounting estimate is notable due to the projected magnitude of the positive impact on pre-tax income.

This is Microsoft’s first disclosed change in accounting estimate. This is not particularly unusual; 50% of Microsoft’s compensation peers have disclosed one or no changes in estimates, while over 56% of the S&P 500 have disclosed one or no changes in estimates. However, the change is anticipated to positively impact Microsoft’s pre-tax income by $2,700 million, making it the top impact on pre-tax income disclosed by an S&P 500 company.

Microsoft's change in accounting estimate related to S&P 500

As is evidenced by Microsoft, changes in accounting estimates can have a significant impact on earnings, making them an important component of financial statements for analysts and investors. One-off changes can be used to potentially hide bad quarters or mislead investors. Many changes result in short-term gains followed by longer-term losses; in the short-term, companies may be able to meet or beat earnings goals, but estimate changes of this nature aren’t sustainable.

This analysis uses data from the Changes in Accounting Estimates database, powered by Audit Analytics.

For more information about Audit Analytics or this analysis, please contact us.

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