Quarterly Report


Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM 10-Q

 


 

x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended December 31, 2011

OR

 

¨

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period From                 to                 

Commission File Number: 0-14278

 


MICROSOFT CORPORATION

(Exact name of registrant as specified in its charter)

 


 

Washington   91-1144442

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

One Microsoft Way, Redmond, Washington   98052-6399
(Address of principal executive offices)   (Zip Code)

(425) 882-8080

(Registrant’s telephone number, including area code)

None

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  x  No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  x  No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer  x

  

Accelerated filer  ¨

Non-accelerated filer  ¨ (Do not check if a smaller reporting company)

  

Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  ¨  No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class    Outstanding at January 17, 2012  


Common Stock, $0.00000625 par value per share

     8,390,771,388 shares   



Table of Contents

MICROSOFT CORPORATION

FORM 10-Q

For the Quarter Ended December 31, 2011

INDEX

 

                 Page  

PART I.

  FINANCIAL INFORMATION        
    Item 1.   Financial Statements        
        a)    Income Statements for the Three and Six Months Ended December 31, 2011 and 2010     3   
        b)    Balance Sheets as of December 31, 2011 and June 30, 2011     4   
        c)    Cash Flows Statements for the Three and Six Months Ended December 31, 2011 and 2010     5   
        d)    Stockholders’ Equity Statements for the Three and Six Months Ended December 31, 2011 and 2010     6   
        e)    Notes to Financial Statements     7   
        f)    Report of Independent Registered Public Accounting Firm     27   
    Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations     28   
    Item 3.   Quantitative and Qualitative Disclosures About Market Risk     44   
    Item 4.   Controls and Procedures     45   

PART II.

  OTHER INFORMATION        
    Item 1.   Legal Proceedings     45   
    Item 1A.   Risk Factors     45   
    Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds     51   
    Item 6.   Exhibits     52   

SIGNATURE

    53   

 

2


Table of Contents

PART I

Item 1

 

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

INCOME STATEMENTS

 

(In millions, except per share amounts) (Unaudited)    Three Months Ended
December 31,
    Six Months Ended
December 31,
 


     2011     2010     2011     2010  

Revenue

   $   20,885      $   19,953      $   38,257      $   36,148   

Operating expenses:

                                

Cost of revenue

     5,638        4,833        9,415        7,972   

Research and development

     2,371        2,185        4,700        4,381   

Sales and marketing

     3,762        3,825        6,662        6,631   

General and administrative

     1,120        945        2,283        1,883   


 


 


 


Total operating expenses

     12,891        11,788        23,060        20,867   


 


 


 


Operating income

     7,994        8,165        15,197        15,281   

Other income

     245        332        348        446   


 


 


 


Income before income taxes

     8,239        8,497        15,545        15,727   

Provision for income taxes

     1,615        1,863        3,183        3,683   


 


 


 


Net income

   $ 6,624      $ 6,634      $ 12,362      $ 12,044   
    


 


 


 


Earnings per share:

                                

Basic

   $ 0.79      $ 0.78      $ 1.47      $ 1.41   

Diluted

   $ 0.78      $ 0.77      $ 1.46      $ 1.39   

Weighted average shares outstanding:

                                

Basic

     8,402        8,497        8,397        8,555   

Diluted

     8,465        8,570        8,489        8,646   

Cash dividends declared per common share

   $ 0.20      $ 0.16      $ 0.40      $ 0.32   


See accompanying notes.

 

3


Table of Contents

PART I

Item 1

 

BALANCE SHEETS

 

(In millions) (Unaudited)             


December 31,

2011

  

  

   
 
June 30,
2011
  
(1)  

Assets

                

Current assets:

                

Cash and cash equivalents

   $ 10,610      $ 9,610   

Short-term investments (including securities loaned of $831 and $1,181)

     41,126        43,162   


 


Total cash, cash equivalents, and short-term investments

     51,736        52,772   

Accounts receivable, net of allowance for doubtful accounts of $321 and $333

     13,643        14,987   

Inventories

     1,351        1,372   

Deferred income taxes

     2,169        2,467   

Other

     3,614        3,320   


 


Total current assets

     72,513        74,918   

Property and equipment, net of accumulated depreciation of $10,546 and $9,829

     8,010        8,162   

Equity and other investments

     7,550        10,865   

Goodwill

     19,670        12,581   

Intangible assets, net

     2,581        744   

Other long-term assets

     1,919        1,434   


 


Total assets

   $   112,243      $   108,704   
    


 


Liabilities and stockholders’ equity

                

Current liabilities:

                

Accounts payable

   $ 3,884      $ 4,197   

Accrued compensation

     2,677        3,575   

Income taxes

     921        580   

Short-term unearned revenue

     13,985        15,722   

Securities lending payable

     849        1,208   

Other

     3,057        3,492   


 


Total current liabilities

     25,373        28,774   

Long-term debt

     11,932        11,921   

Long-term unearned revenue

     1,349        1,398   

Deferred income taxes

     1,082        1,456   

Other long-term liabilities

     8,386        8,072   


 


Total liabilities

     48,122        51,621   


 


Commitments and contingencies

                

Stockholders’ equity:

                

Common stock and paid-in capital—shares authorized 24,000; outstanding 8,382 and 8,376

     63,902        63,415   

Retained earnings (deficit), including accumulated other comprehensive income of $826 and $1,863

     219        (6,332


 


Total stockholders’ equity

     64,121        57,083   


 


Total liabilities and stockholders’ equity

   $ 112,243      $ 108,704   
    


 


 

(1)

Derived from audited financial statements.

See accompanying notes.

 

4


Table of Contents

PART I

Item 1

 

CASH FLOWS STATEMENTS

 

(In millions) (Unaudited)   

Three Months Ended

December 31,

   

Six Months Ended

December 31,

 


     2011     2010     2011     2010  

Operations

                                

Net income

   $ 6,624      $ 6,634      $ 12,362      $ 12,044   

Adjustments to reconcile net income to net cash from operations:

                                

Depreciation, amortization, and other

     678        663        1,404        1,357   

Stock-based compensation expense

     575        553        1,133        1,081   

Net recognized gains on investments and derivatives

     (112     (226     (142     (255

Excess tax benefits from stock-based compensation

     (4     (4     (74     (9

Deferred income taxes

     14        (117     416        (265

Deferral of unearned revenue

     7,544        6,834        13,683        12,715   

Recognition of unearned revenue

        (8,057        (7,301        (15,710       (14,163

Changes in operating assets and liabilities:

                                

Accounts receivable

     (3,652     (3,270     1,081        404   

Inventories

     891        380        (29     (88

Other current assets

     605        (77     865        131   

Other long-term assets

     30        118        (45     180   

Accounts payable

     176        216        (266     (184

Other current liabilities

     394        (500     (599     (1,411

Other long-term liabilities

     156        283        276        843   


 


 


 


Net cash from operations

     5,862        4,186        14,355        12,380   


 


 


 


Financing

                                

Short-term debt repayments, maturities of 90 days or less, net

     0        (1,000     0        (186

Proceeds from issuance of debt, maturities longer than 90 days

     0        0        0        4,721   

Repayments of debt, maturities longer than 90 days

     0        0        0        (814

Common stock issued

     208        660        544        837   

Common stock repurchased

     (1,042     (5,052     (2,976     (9,451

Common stock cash dividends paid

     (1,683     (1,363     (3,024     (2,481

Excess tax benefits from stock-based compensation

     4        4        74        9   

Other

     0        0        0        (25


 


 


 


Net cash used in financing

     (2,513     (6,751     (5,382     (7,390


 


 


 


Investing

                                

Additions to property and equipment

     (498     (491     (934     (1,055

Acquisition of companies, net of cash acquired, and purchases of intangible and other assets

     (8,627     (69     (9,502     (69

Purchases of investments

        (10,047     (5,896     (21,346     (13,313

Maturities of investments

     6,061        1,836        8,886        2,706   

Sales of investments

     7,835        2,603        15,371        4,030   

Securities lending payable

     (292     447        (358     1,174   


 


 


 


Net cash used in investing

     (5,568     (1,570     (7,883     (6,527


 


 


 


Effect of exchange rates on cash and cash equivalents

     (52     (3     (90     55   


 


 


 


Net change in cash and cash equivalents

     (2,271     (4,138     1,000        (1,482

Cash and cash equivalents, beginning of period

     12,881        8,161        9,610        5,505   


 


 


 


Cash and cash equivalents, end of period

   $ 10,610      $ 4,023      $ 10,610      $ 4,023   
    


 


 


 


See accompanying notes.

 

5


Table of Contents

PART I

Item 1

 

STOCKHOLDERS’ EQUITY STATEMENTS

 

(In millions) (Unaudited)   

Three Months Ended

December 31,

   

Six Months Ended

December 31,

 


     2011     2010     2011     2010  

Common stock and paid-in capital

                                

Balance, beginning of period

   $   63,492      $   61,935      $   63,415      $   62,856   

Common stock issued

     208        660        544        837   

Common stock repurchased

     (340     (1,405     (1,164     (2,980

Stock-based compensation expense

     575        553        1,133        1,081   

Stock-based compensation income tax deficiencies

     (35     (97     (29     (148

Other, net

     2        0        3        0   


 


 


 


Balance, end of period

     63,902        61,646        63,902        61,646   


 


 


 


Retained earnings (deficit)

                                

Balance, beginning of period

     (4,101     (14,993     (6,332     (16,681

Net income

     6,624        6,634        12,362        12,044   

Other comprehensive income:

                                

Net unrealized gains (losses) on derivatives

     76        (80     236        (586

Net unrealized gains (losses) on investments

     124        284        (1,025     1,016   

Translation adjustments and other

     (125     (26     (248     212   


 


 


 


Comprehensive income

     6,699        6,812        11,325        12,686   

Common stock cash dividends

     (1,677     (1,337     (3,360     (2,699

Common stock repurchased

     (702     (3,647     (1,414     (6,471


 


 


 


Balance, end of period

     219        (13,165     219        (13,165


 


 


 


Total stockholders’ equity

   $ 64,121      $ 48,481      $ 64,121      $ 48,481   
    


 


 


 


See accompanying notes.

 

6


Table of Contents

PART I

Item 1

 

NOTES TO FINANCIAL STATEMENTS

(Unaudited)

NOTE 1    ACCOUNTING POLICIES

Accounting Principles

In the opinion of management, the accompanying balance sheets and related interim statements of income, cash flows, and stockholders’ equity include all adjustments, consisting only of normal recurring items, necessary for their fair presentation in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”). Interim results are not necessarily indicative of results for a full year. The information included in this Form 10-Q should be read in conjunction with information included in the Microsoft Corporation 2011 Form 10-K filed on July 28, 2011 with the U.S. Securities and Exchange Commission.

Principles of Consolidation

The financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments through which we exercise significant influence over but do not control the investee and are not the primary beneficiary of the investee’s activities are accounted for using the equity method. Investments through which we are not able to exercise significant influence over the investee and which do not have readily determinable fair values are accounted for under the cost method.

Estimates and Assumptions

Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples include: estimates of loss contingencies, product warranties, product life cycles, product returns, and stock-based compensation forfeiture rates; assumptions such as the elements comprising a software arrangement, including the distinction between upgrades/enhancements and new products; when technological feasibility is achieved for our products; the potential outcome of future tax consequences of events that have been recognized in our financial statements or tax returns; estimating the fair value and/or potential goodwill impairment for our reporting units; and determining when investment impairments are other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions.

Recently Adopted Accounting Guidance

On July 1, 2011, we adopted guidance issued by the Financial Accounting Standards Board (“FASB”) on disclosure requirements related to fair value measurements. The guidance requires the disclosure of roll-forward activities on purchases, sales, issuance, and settlements of the assets and liabilities measured using significant unobservable inputs (Level 3 fair value measurements). Adoption of this new guidance did not have a material impact on our financial statements.

Recent Accounting Guidance Not Yet Adopted

In December 2011, the FASB issued guidance enhancing disclosure requirements about the nature of an entity’s right to offset and related arrangements associated with its financial instruments and derivative instruments. The new guidance requires the disclosure of the gross amounts subject to rights of set-off, amounts offset in accordance with the accounting standards followed, and the related net exposure. The new guidance will be effective for us beginning July 1, 2013. Other than requiring additional disclosures, we do not anticipate material impacts on our financial statements upon adoption.

In September 2011, the FASB issued guidance on testing goodwill for impairment. The new guidance provides an entity the option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If an entity determines that this is the case, it is required to perform the currently prescribed two-step goodwill impairment test to identify potential goodwill impairment and measure the amount of goodwill impairment loss to be recognized for that reporting unit (if any). If an entity determines that the fair value of a reporting unit is greater than its carrying amount, the two-step goodwill impairment test is not required. The new guidance will be effective for us beginning July 1, 2012.

In June 2011, the FASB issued guidance on presentation of comprehensive income. The new guidance eliminates the current option to report other comprehensive income and its components in the statement of changes in equity. Instead,

 

7


Table of Contents

PART I

Item 1

 

an entity will be required to present either a continuous statement of net income and other comprehensive income or in two separate but consecutive statements. The new guidance also required entities to present reclassification adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which other comprehensive income is presented. In December 2011, the FASB issued guidance which indefinitely defers the guidance related to the presentation of reclassification adjustments. The new guidance will be effective for us beginning July 1, 2012 and will have financial statement presentation changes only.

In May 2011, the FASB issued guidance to amend the accounting and disclosure requirements on fair value measurements. The new guidance limits the highest-and-best-use measure to nonfinancial assets, permits certain financial assets and liabilities with offsetting positions in market or counterparty credit risks to be measured at a net basis, and provides guidance on the applicability of premiums and discounts. Additionally, the new guidance expands the disclosures on Level 3 inputs by requiring quantitative disclosure of the unobservable inputs and assumptions, as well as description of the valuation processes and the sensitivity of the fair value to changes in unobservable inputs. The new guidance will be effective for us beginning January 1, 2012. Other than requiring additional disclosures, we do not anticipate material impacts on our financial statements upon adoption.

NOTE 2    EARNINGS PER SHARE

Basic earnings per share (“EPS”) is computed based on the weighted average number of shares of common stock outstanding during the period. Diluted EPS is computed based on the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options, stock awards, and shared performance stock awards. The components of basic and diluted EPS are as follows:

 

(In millions, except earnings per share)   

Three Months Ended

December 31,

   

Six Months Ended

December 31,

 


     2011     2010     2011     2010  

Net income available for common shareholders (A)

   $   6,624      $   6,634      $   12,362      $   12,044   

Weighted average outstanding shares of common stock (B)

     8,402        8,497        8,397        8,555   

Dilutive effect of stock-based awards

     63        73        92        91   


 


 


 


Common stock and common stock equivalents (C)

     8,465        8,570        8,489        8,646   
    


 


 


 


Earnings Per Share:

                                

Basic (A/B)

   $ 0.79      $ 0.78      $ 1.47      $ 1.41   

Diluted (A/C)

   $ 0.78      $ 0.77      $ 1.46      $ 1.39   


We excluded the following shares underlying stock-based awards from the calculations of diluted EPS because their inclusion would have been anti-dilutive:

 

(In millions)   

Three Months Ended

December 31,

  

Six Months Ended

December 31,


     2011    2010    2011    2010

Shares excluded from calculations of diluted EPS

   4    56    4    57

The decrease in anti-dilutive shares from the comparable period was due mainly to the decrease in employee stock options outstanding.

In June 2010, we issued $1.25 billion of zero-coupon debt securities that are convertible into shares of our common stock if certain conditions are met. As of December 31, 2011, none of these securities had met price or other conditions that would make them eligible for issuance and therefore were excluded from the calculation of either the basic or diluted EPS. See Note 11 – Debt for additional information.

 

8


Table of Contents

PART I

Item 1

 

NOTE 3    OTHER INCOME

The components of other income were as follows:

 

(In millions)   

Three Months Ended

December 31,

   

Six Months Ended

December 31,

 


       2011        2010        2011        2010   

Dividends and interest income

   $   182      $   205      $   393      $   415   

Interest expense

     (95     (72     (189     (117

Net recognized gains on investments

     315        118        318        152   

Net gains (losses) on derivatives

     (203     108        (176     103   

Net losses on foreign currency remeasurements

     (4     (27     (44     (69

Other

     50        0        46        (38


 


 


 


Total

   $ 245      $ 332      $ 348      $ 446   
    


 


 


 


Following are details of net recognized gains on investments during the periods reported:

 

(In millions)   

Three Months Ended

December 31,

   

Six Months Ended

December 31,

 


       2011        2010        2011        2010   

Other-than-temporary impairments of investments

   $   (107   $ (18   $   (152   $ (27

Realized gains from sales of available-for-sale securities

     643        214        843        315   

Realized losses from sales of available-for-sale securities

     (221     (78     (373     (136


 


 


 


Total

   $ 315      $   118      $ 318      $   152   
    


 


 


 


NOTE 4    INVESTMENTS

Investment Components

The components of investments, including associated derivatives, were as follows:

 

(In millions)    Cost Basis    

Unrealized

Gains

   

Unrealized

Losses

   

Recorded

Basis

   

Cash

and Cash

Equivalents

   

Short-term

Investments

   

Equity

and Other

Investments

 


December 31, 2011                                           

Cash

   $ 2,349      $ 0      $ 0      $ 2,349      $ 2,349      $ 0      $ 0   

Mutual funds

     816        0        0        816        816        0        0   

Commercial paper

     465        0        0        465        350        115        0   

Certificates of deposit

     1,003        0        0        1,003        688        315        0   

U.S. government and agency securities

     31,548        153        (1     31,700        510        31,190        0   

Foreign government bonds

     888        26        (32     882        0        882        0   

Mortgage-backed securities

     1,910        111        (3     2,018        0        2,018        0   

Corporate notes and bonds

     11,891        180        (29     12,042        5,897        6,145        0   

Municipal securities

     403        54        0        457        0        457        0   

Common and preferred stock

     6,044        1,274        (478     6,840        0        0        6,840   

Other investments

     714        0        0        714        0        4        710   


 


 


 


 


 


 


Total

   $   58,031      $   1,798      $   (543   $   59,286      $   10,610      $   41,126      $   7,550   
    


 


 


 


 


 


 


 

9


Table of Contents

PART I

Item 1

 

(In millions)    Cost Basis    

Unrealized

Gains

    Unrealized
Losses
    Recorded
Basis
    Cash
and Cash
Equivalents
    Short-term
Investments
    Equity
and Other
Investments
 


June 30, 2011                                           

Cash

   $ 1,648      $ 0      $ 0      $ 1,648      $ 1,648      $ 0      $ 0   

Mutual funds

     1,752        0        0        1,752        1,752        0        0   

Commercial paper

     639        0        0        639        414        225        0   

Certificates of deposit

     598        0        0        598        372        226        0   

U.S. government and agency securities

     33,607        162        (7     33,762        2,049        31,713        0   

Foreign government bonds

     658        11        (2     667        0        667        0   

Mortgage-backed securities

     2,307        121        (4     2,424        0        2,424        0   

Corporate notes and bonds

     10,575        260        (11     10,824        3,375        7,449        0   

Municipal securities

     441        15        (2     454        0        454        0   

Common and preferred stock

     7,925        2,483        (193     10,215        0        0        10,215   

Other investments

     654        0        0        654        0        4        650   


 


 


 


 


 


 


Total

   $   60,804      $   3,052      $   (219   $   63,637      $   9,610      $   43,162      $   10,865   
    


 


 


 


 


 


 


Unrealized Losses on Investments

Investments with continuous unrealized losses for less than 12 months and 12 months or greater and their related fair values were as follows:

 

     Less than 12 Months     12 Months or Greater          

Total

Unrealized

Losses

 
    


 


         
(In millions)    Fair Value     Unrealized
Losses
    Fair Value     Unrealized
Losses
    Total
Fair Value
   


December 31, 2011                                     

U.S. government and agency securities

   $   1,140      $ (1   $ 0      $ 0      $ 1,140      $ (1

Foreign government bonds

     268        (32     0        0        268        (32

Mortgage-backed securities

     0        0        54        (3     54        (3

Corporate notes and bonds

     1,167        (28     32        (1     1,199        (29

Common and preferred stock

     1,954        (440     109        (38     2,063        (478


 


 


 


 


 


Total

   $ 4,529      $   (501   $   195      $   (42   $   4,724      $   (543
    


 


 


 


 


 


 

     Less than 12 Months     12 Months or Greater          

Total

Unrealized

Losses

 
    


 


         
(In millions)    Fair Value     Unrealized
Losses
    Fair Value     Unrealized
Losses
    Total
Fair Value
   


June 30, 2011                                     

U.S. government and agency securities

   $ 484      $ (7   $ 0      $ 0      $ 484      $ (7

Foreign government bonds

     365        (2     0        0        365        (2

Mortgage-backed securities

     63        (3     14        (1     77        (4

Corporate notes and bonds

     750        (10     25        (1     775        (11

Municipal securities

     79        (2     0        0        79        (2

Common and preferred stock

     1,377        (146     206        (47     1,583        (193


 


 


 


 


 


Total

   $   3,118      $   (170   $   245      $   (49   $   3,363      $   (219
    


 


 


 


 


 


Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic and international equities are due to market price movements. Management does not believe any remaining unrealized losses represent other-than-temporary impairments based on our evaluation of available evidence as of December 31, 2011.

 

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Item 1

 

At December 31, 2011 and June 30, 2011, the recorded bases of common and preferred stock and other investments that are restricted for more than one year or are not publicly traded were $433 million and $334 million, respectively. These investments are carried at cost and are reviewed quarterly for indicators of other-than-temporary impairment.

Debt Investment Maturities

 

(In millions)    Cost Basis    

Estimated

Fair Value

 


December 31, 2011             

Due in one year or less

   $ 24,231      $ 24,275   

Due after one year through five years

     18,304        18,432   

Due after five years through 10 years

     3,126        3,247   

Due after 10 years

     2,447        2,613   


 


Total

   $   48,108      $   48,567   
    


 


NOTE 5    DERIVATIVES

We use derivative instruments to: manage risks related to foreign currencies, equity prices, interest rates, and credit; to enhance investment returns; and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Our derivative programs include strategies that both qualify and do not qualify for hedge accounting treatment. All notional amounts presented below are measured in U.S. currency equivalents.

Foreign Currency

Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge positions. Option and forward contracts are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash flow hedging instruments. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. As of December 31, 2011 and June 30, 2011, the total notional amounts of these foreign exchange contracts sold were $9.4 billion and $10.6 billion, respectively.

Foreign currency risks related to certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are designated as fair value hedging instruments. As of December 31, 2011 and June 30, 2011, the total notional amounts of these foreign exchange contracts sold were $481 million and $572 million, respectively.

Certain options and forwards not designated as hedging instruments are also used to manage the variability in exchange rates on accounts receivable, cash, and intercompany positions, and to manage other foreign currency exposures. As of December 31, 2011, the total notional amounts of these foreign exchange contracts purchased and sold were $3.0 billion and $7.0 billion, respectively. As of June 30, 2011, the total notional amounts of these foreign exchange contracts purchased and sold were $4.3 billion and $7.1 billion, respectively.

Equity

Securities held in our equity and other investments portfolio are subject to market price risk. Market price risk is managed relative to broad-based global and domestic equity indices using certain convertible preferred investments, options, futures, and swap contracts not designated as hedging instruments. From time to time, to hedge our price risk, we may use and designate equity derivatives as hedging instruments, including puts, calls, swaps, and forwards. As of December 31, 2011, the total notional amounts of designated and non-designated equity contracts purchased and sold were $1.1 billion and $779 million, respectively. As of June 30, 2011, the total notional amounts of designated and non-designated equity contracts purchased and sold were $1.1 billion and $860 million, respectively.

 

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Item 1

 

Interest Rate

Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of our fixed-income portfolio to achieve economic returns that correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts and over-the-counter swap and option contracts, none of which are designated as hedging instruments. As of December 31, 2011, the total notional amounts of fixed-interest rate contracts purchased and sold were $1.2 billion and $846 million, respectively. As of June 30, 2011, the total notional amounts of fixed-interest rate contracts purchased and sold were $2.3 billion and $697 million, respectively.

In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed securities. These meet the definition of a derivative instrument in cases where physical delivery of the assets is not taken at the earliest available delivery date. As of December 31, 2011 and June 30, 2011, the total notional derivative amount of mortgage contracts purchased were $1.1 billion and $868 million, respectively.

Credit

Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts, not designated as hedging instruments, to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. We use credit default swaps as they are a low-cost method of managing exposure to individual credit risks or groups of credit risks. As of December 31, 2011, the total notional amounts of credit contracts purchased and sold were $221 million and $297 million, respectively. As of June 30, 2011, the total notional amounts of credit contracts purchased and sold were $532 million and $281 million, respectively.

Commodity

We use broad-based commodity exposures to enhance portfolio returns and to facilitate portfolio diversification. We use swap, futures and option contracts, not designated as hedging instruments, to generate and manage exposures to broad-based commodity indices. We use derivatives on commodities as they can be low-cost alternatives to the purchase and storage of a variety of commodities, including, but not limited to, precious metals, energy, and grain. As of December 31, 2011, the total notional amounts of commodity contracts purchased and sold were $1.3 billion and $458 million, respectively. As of June 30, 2011, the total notional amounts of commodity contracts purchased and sold were $1.9 billion and $502 million, respectively.

Credit-Risk-Related Contingent Features

Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured debt to maintain an investment grade credit rating and require us to maintain a minimum liquidity of $1.0 billion. To the extent we fail to meet these requirements, we will be required to post collateral, similar to the standard convention related to over-the-counter derivatives. As of December 31, 2011, our long-term unsecured debt rating was AAA, and cash investments were in excess of $1.0 billion. As a result, no collateral was required to be posted.

Fair Values of Derivative Instruments

Derivative instruments are recognized as either assets or liabilities and are measured at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation.

For derivative instruments designated as fair value hedges, the gain (loss) is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged items attributed to the risk being hedged. For options designated as fair-value hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings.

For derivative instruments designated as cash-flow hedges, the effective portion of the derivative’s gain (loss) is initially reported as a component of other comprehensive income (“OCI”) and is subsequently recognized in earnings when the hedged exposure is recognized in earnings. For options designated as cash-flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. Gains (losses) on derivatives representing either hedge components excluded from the assessment of effectiveness or hedge ineffectiveness are recognized in earnings.

 

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Table of Contents

PART I

Item 1

 

For derivative instruments that are not designated as hedges, gains (losses) from changes in fair values are primarily recognized in other income (expense). Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities, which are recorded as a component of OCI until the securities are sold or other-than-temporarily impaired, at which time the amounts are moved from OCI into other income (expense).

The following tables present the gross fair values of derivative instruments designated as hedging instruments (“designated hedge derivatives”) and not designated as hedging instruments (“non-designated hedge derivatives”). The fair values exclude the impact of netting derivative assets and liabilities when a legally enforceable master netting agreement exists and fair value adjustments related to our own credit risk and counterparty credit risk:

 

(In millions)   

Foreign

Exchange

Contracts

   

Equity

Contracts

   

Interest

Rate

Contracts

   

Credit

Contracts

   

Commodity

Contracts

   

Total

Derivatives

 


December 31, 2011                                     

Assets

                                                

Non-designated hedge derivatives:

                                                

Short-term investments

   $ 36      $   136      $ 14      $ 27      $ 6      $ 219   

Other current assets

     127        0        0        0        0        127   


 


 


 


 


 


Total

   $ 163      $ 136      $ 14      $ 27      $ 6      $ 346   

Designated hedge derivatives:

                                                

Short-term investments

   $ 9      $ 0      $ 0      $ 0      $ 0      $ 9   

Other current assets

     330        0        0        0        0        330   


 


 


 


 


 


Total

   $ 339      $ 0      $ 0      $ 0      $ 0      $ 339   
    


 


 


 


 


 


Total assets

   $ 502      $ 136      $ 14      $ 27      $ 6      $ 685   
    


 


 


 


 


 


Liabilities

                                                

Non-designated hedge derivatives:

                                                

Other current liabilities

   $ (108   $ (11   $ (22   $ (20   $ (3   $ (164

Designated hedge derivatives:

                                                

Other current liabilities

   $ (30   $ 0      $ 0      $ 0      $ 0      $ (30


 


 


 


 


 


Total liabilities

   $   (138   $ (11   $   (22   $   (20   $   (3   $   (194
    


 


 


 


 


 


 

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Table of Contents

PART I

Item 1

 

(In millions)   

Foreign

Exchange

Contracts

   

Equity

Contracts

   

Interest

Rate

Contracts

   

Credit

Contracts

   

Commodity

Contracts

   

Total

Derivatives

 


June 30, 2011                                     

Assets

                                                

Non-designated hedge derivatives:

                                                

Short-term investments

   $ 14      $ 179      $ 0      $ 17      $ 4      $ 214   

Other current assets

     73        0        0        0        0        73   


 


 


 


 


 


Total

   $ 87      $ 179      $ 0      $ 17      $ 4      $ 287   

Designated hedge derivatives:

                                                

Short-term investments

   $ 6      $ 0      $ 0      $ 0      $ 0      $ 6   

Other current assets

     123        0        0        0        0        123   


 


 


 


 


 


Total

   $ 129      $ 0      $ 0      $ 0      $ 0      $ 129   
    


 


 


 


 


 


Total assets

   $ 216      $ 179      $ 0      $ 17      $ 4      $ 416   
    


 


 


 


 


 


Liabilities

                                                

Non-designated hedge derivatives:

                                                

Other current liabilities

   $ (91   $ (12   $ (9   $ (19   $ (4   $ (135

Designated hedge derivatives:

                                                

Other current liabilities

   $ (128   $ 0      $ 0      $ 0      $ 0      $ (128


 


 


 


 


 


Total liabilities

   $   (219   $   (12   $   (9   $   (19   $   (4   $   (263
    


 


 


 


 


 


See also Note 4 – Investments and Note 6 – Fair Value Measurements.

Fair-Value Hedge Gains (Losses)

We recognized in other income the following gains (losses) on contracts designated as fair value hedges and their related hedged items:

 

(In millions)   

Three Months Ended

December 31,

   

Six Months Ended

December 31,

 


     2011     2010     2011     2010  

Foreign Exchange Contracts

                                

Derivatives

   $ 4      $ 2      $ 48      $   (50

Hedged items

     (5       (2       (48     48   


 


 


 


Total

   $   (1   $ 0      $   0      $   (2
    


 


 


 


Cash Flow Hedge Gains (Losses)

We recognized the following gains (losses) on foreign exchange contracts designated as cash flow hedges (our only cash flow hedges during the periods presented):

 

(In millions)   

Three Months Ended

December 31,

   

Six Months Ended

December 31,

 


     2011     2010     2011     2010  

Effective Portion

                                

Gain (loss) recognized in OCI, net of tax effect of $33 and $(24) for the three months ended December 31, 2011 and 2010, and $102 and $(267) for the six months ended December 31, 2011 and 2010

   $ 62      $   (45   $   190      $   (497

Gain (loss) reclassified from OCI into revenue

     (21     55        (70     139   

Amount Excluded from Effectiveness Assessment and Ineffective Portion

                                

Loss recognized in other income

       (127     (16     (65     (103


 

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Table of Contents

PART I

Item 1

 

We estimate that $84 million of net derivative gains included in OCI at December 31, 2011 will be reclassified into earnings within the following 12 months. No significant amounts of gains (losses) were reclassified from OCI into earnings as a result of forecasted transactions that failed to occur during the three and six months ended December 31, 2011.

Non-Designated Derivative Gains (Losses)

Gains (losses) from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense). These amounts are shown in the table below, with the exception of gains (losses) on derivatives presented in income statement line items other than other income (expense), which were immaterial for the periods presented. Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) below are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities.

 

(In millions)   

Three Months Ended

December 31,

   

Six Months Ended

December 31,

 


     2011     2010     2011     2010  

Foreign exchange contracts

   $ (16   $ (25   $ (65   $ (85

Equity contracts

     (79     (2     (68     31   

Interest-rate contracts

     15        24        58        12   

Credit contracts

     10        10        (7     28   

Commodity contracts

     2        93        (88     158   


 


 


 


Total

   $   (68   $   100      $   (170   $   144   
    


 


 


 


NOTE 6    FAIR VALUE MEASUREMENTS

We account for certain assets and liabilities at fair value. The hierarchy below lists three levels of fair value based on the extent to which inputs used in measuring fair value are observable in the market. We categorize each of our fair value measurements in one of these three levels based on the lowest level input that is significant to the fair value measurement in its entirety. These levels are:

 

   

Level 1 —inputs are based upon unadjusted quoted prices for identical instruments traded in active markets. Our Level 1 non-derivative investments primarily include U.S. treasuries, domestic and international equities, and actively traded mutual funds. Our Level 1 derivative assets and liabilities include those actively traded on exchanges.

 

   

Level 2 —inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques (e.g. the Black-Scholes model) for which all significant inputs are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, foreign exchange rates, and forward and spot prices for currencies and commodities. Our Level 2 non-derivative investments consist primarily of corporate notes and bonds, mortgage-backed securities, agency securities, certificates of deposit, and commercial paper. Our Level 2 derivative assets and liabilities primarily include certain over-the-counter option and swap contracts.

 

   

Level 3 —inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques, including option pricing models and discounted cash flow models. Our Level 3 non-derivative assets primarily comprise investments in certain corporate bonds. We value these corporate bonds using internally developed valuation models, inputs to which include interest rate curves, credit spreads, stock prices, and volatilities. Unobservable inputs used in these models are significant to the fair values of the investments. Our Level 3 derivative assets and liabilities primarily comprise derivatives for foreign equities. In certain cases, market-based observable inputs are not available and we use management judgment to develop assumptions to determine fair value for these derivatives.

We measure certain assets, including our cost and equity method investments, at fair value on a nonrecurring basis when they are deemed to be other-than-temporarily impaired. The fair values of these investments are determined based on valuation techniques using the best information available, and may include quoted market prices, market comparables, and discounted cash flow projections. An impairment charge is recorded when the cost of the investment exceeds its fair value and this condition is determined to be other-than-temporary.

 

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Table of Contents

PART I

Item 1

 

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The following tables present the fair value of our financial instruments that are measured at fair value on a recurring basis:

 

(In millions)

     Level 1        Level 2        Level 3       

 

Gross Fair

Value

  

  

    Netting (a)      
 
Net Fair
Value
  
  


December 31, 2011                                     

Assets

                                                

Mutual funds

   $ 816       $ 0       $ 0       $ 816       $ 0      $ 816   

Commercial paper

     0        465        0        465        0        465   

Certificates of deposit

     0        1,003        0        1,003        0        1,003   

U.S. government and agency securities

     23,240        8,467        0        31,707        0        31,707   

Foreign government bonds

     178        692        0        870        0        870   

Mortgage-backed securities

     0        2,010        0        2,010        0        2,010   

Corporate notes and bonds

     0        11,898        9        11,907        0        11,907   

Municipal securities

     0        457        0        457        0        457   

Common and preferred stock

     6,354        49        5        6,408        0        6,408   

Derivatives

     5        680        0        685        (185     500   


 


 


 


 


 


Total

   $   30,593      $   25,721      $   14      $   56,328      $   (185   $   56,143   
    


 


 


 


 


 


Liabilities

                                                

Derivatives and other

   $ 4      $ 190      $ 0      $ 194      $ (182   $ 12   


 

(In millions)

     Level 1        Level 2        Level 3       

 

Gross Fair

Value

  

  

    Netting (a)      
 
Net Fair
Value
  
  


June 30, 2011                                     

Assets

                                                

Mutual funds

   $ 1,752       $ 0       $ 0       $ 1,752       $ 0      $ 1,752   

Commercial paper

     0        639        0        639        0        639   

Certificates of deposit

     0        598        0        598        0        598   

U.S. government and agency securities

     23,591        10,175        0        33,766        0        33,766   

Foreign government bonds

     303        367        0        670        0        670   

Mortgage-backed securities

     0        2,428        0        2,428        0        2,428   

Corporate notes and bonds

     0        10,600        58        10,658        0        10,658   

Municipal securities

     0        454        0        454        0        454   

Common and preferred stock

     9,821        55        5        9,881        0        9,881   

Derivatives

     8        388        20        416        (204     212   


 


 


 


 


 


Total

   $   35,475      $   25,704      $   83      $   61,262      $   (204   $   61,058   
    


 


 


 


 


 


Liabilities

                                                

Derivatives and other

   $ 109      $ 257      $ 0      $ 366      $ (203   $ 163   


 

(a)

These amounts represent the impact of netting derivative assets and derivative liabilities when a legally enforceable master netting agreement exists and fair value adjustments related to our own credit risk and counterparty credit risk.

 

16


Table of Contents

PART I

Item 1

 

The following table reconciles the total Net Fair Value of assets above to the balance sheet presentation of these same assets in Note 4 – Investments.

 

(In millions)             


    

December 31,

2011

   

June 30,

2011

 

Net fair value of assets measured at fair value on a recurring basis

   $   56,143      $   61,058   

Cash

     2,349        1,648   

Common and preferred stock measured at fair value on a nonrecurring basis

     433        334   

Other investments measured at fair value on a nonrecurring basis

     710        650   

Less derivative assets classified as other current assets

     (350     (54

Other

     1        1   


 


Recorded basis of investment components

   $ 59,286      $ 63,637   
    


 


Changes in Financial Instruments Measured at Level 3 Fair Value on a Recurring Basis

The following tables present the changes during the periods presented in our Level 3 financial instruments that are measured at fair value on a recurring basis. The majority of these instruments consist of investment securities classified as available-for-sale with changes in fair value included in OCI.

 

(In millions)    Corporate
Notes and
Bonds
    Common
and
Preferred
Stock
    Derivative
Assets
    Total  


Three and Six Months Ended December 31, 2011                         

Balance as of June 30, 2011

   $    58      $   5      $    20      $    83   

Total realized and unrealized gains (losses):

                                

Included in other income (expense)

     0        0        (2     (2

Included in other comprehensive income

     (21     0        0        (21


 


 


 


Balance as of September 30, 2011

   $ 37      $ 5      $ 18      $ 60   

Total realized and unrealized gains (losses):

                                

Included in other income (expense)

     0        0        (3     (3

Included in other comprehensive income

     0        0        0        0   

Conversions of Level 3 instruments to Level 1 instruments

     (28     0        (15     (43


 


 


 


Balance as of December 31, 2011

   $ 9      $ 5      $ 0      $ 14   
    


 


 


 


Change in unrealized gains (losses) included in other income (expense) for the three months ended December 31, 2011 related to assets held as of December 31, 2011

   $ 0      $ 0      $ 0      $ 0   

Change in unrealized gains (losses) included in other income (expense) for the six months ended December 31, 2011 related to assets held as of December 31, 2011

   $ 0      $ 0      $ 0      $ 0   


 

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(In millions)    Corporate
Notes and
Bonds
    Common
and
Preferred
Stock
    Derivative
Assets
    Total  


Three and Six Months Ended December 31, 2010                         

Balance as of June 30, 2010

   $   167      $   5      $   9      $   181   

Total realized and unrealized gains (losses):

                                

Included in other income (expense)

     2        0        7        9   

Included in other comprehensive income

     (2     0        0        (2


 


 


 


Balance as of September 30, 2010

   $ 167      $ 5      $ 16      $ 188   

Total realized and unrealized gains (losses):

                                

Included in other income (expense)

     2        0        (1     1   

Included in other comprehensive income

     2        0        0        2   


 


 


 


Balance as of December 31, 2010

   $ 171      $ 5      $ 15      $ 191   
    


 


 


 


Change in unrealized gains (losses) included in other income (expense) for the three months ended December 31, 2010 related to assets held as of December 31, 2010

   $ 2      $ 0      $ (1   $ 1   

Change in unrealized gains (losses) included in other income (expense) for the six months ended December 31, 2010 related to assets held as of December 31, 2010

   $ 4      $ 0      $ 6      $ 10   


Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

During the three and six months ended December 31, 2011 and 2010, we did not record any other-than-temporary impairments on those assets required to be measured at fair value on a nonrecurring basis.

NOTE 7    INVENTORIES

The components of inventories were as follows:

 

(In millions)             


December 31,

2011

   

June 30,

2011

 

Raw materials

   $ 243      $ 232   

Work in process

     81        56   

Finished goods

     1,027        1,084   


 


Total

   $   1,351      $   1,372   
    


 


NOTE 8    BUSINESS COMBINATIONS

On October 13, 2011, we acquired all of the issued and outstanding shares of Skype Global S.á r.l. (“Skype”), a leading global provider of software applications and related Internet communications products based in Luxembourg, for $8.6 billion primarily in cash. Our purchase price allocations are preliminary and subject to revision as more detailed analyses are completed and additional information about fair value of assets and liabilities becomes available, including additional information relating to tax matters and finalization of our valuation of identified intangible assets. The major classes of assets and liabilities to which we preliminarily allocated the purchase price were: goodwill of $7.1 billion; identifiable intangible assets of $1.6 billion with a weighted average estimated useful life of 13 years, primarily marketing-related (trade name) and technology-based intangibles with estimated useful lives of 15 years and 5 years, respectively; and unearned revenue of $222 million. The goodwill recognized in connection with the acquisition is primarily attributable to our expectation of extending Skype’s brand and the reach of its networked platform, while enhancing Microsoft’s existing portfolio of real-time communications products and services. We preliminarily assigned the goodwill to the following segments: $4.2 billion to Entertainment and Devices Division, $2.8 billion to Microsoft Business Division, and $54 million to Online Services Division. Skype was consolidated into our results of operations starting October 13, 2011, the acquisition date.

 

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During the first six months of fiscal year 2012, we completed an additional three acquisitions for total consideration of $83 million, substantially all of which was paid in cash.

Pro forma results of operations have not been presented because the effects of the business combinations described in this Note, individually and in aggregate, were not material to our consolidated results of operations.

NOTE 9    GOODWILL

Changes in the carrying amount of goodwill were as follows:

 

(In millions)   

Balance as of

September 30,

2011

    Acquisitions     Other     Balance as of
December 31,
2011
 


Windows & Windows Live Division

   $ 89      $ 0      $ 0      $ 89   

Server and Tools

     1,144        0        0        1,144   

Online Services Division

     6,373        54        0        6,427   

Microsoft Business Division

     4,119        2,843        (35     6,927   

Entertainment and Devices Division

     812        4,272        (1     5,083   


 


 


 


Total

   $   12,537      $   7,169      $   (36   $   19,670   
    


 


 


 


 

(In millions)   

Balance as of

June 30,

2011

    Acquisitions     Other     Balance as of
December 31,
2011
 


Windows & Windows Live Division

   $ 89      $ 0      $ 0      $ 89   

Server and Tools

     1,139        7        (2     1,144   

Online Services Division

     6,373        54        0        6,427   

Microsoft Business Division

     4,167        2,843        (83     6,927   

Entertainment and Devices Division

     813        4,272        (2     5,083   


 


 


 


Total

   $   12,581      $   7,176      $   (87   $   19,670   
    


 


 


 


We do not expect any of the amounts recorded as goodwill to be deductible for tax purposes. The measurement period for purchase price allocations ends as soon as information on the facts and circumstances becomes available, but will not exceed 12 months. Adjustments in the purchase price allocation may require a recasting of the amounts allocated to goodwill retroactive to the period in which the acquisition occurred. Any change in the goodwill amounts resulting from foreign currency translations are presented as “other” in the above table. Also included within “other” are transfers between business segments due to reorganizations, as applicable.

NOTE 10    INTANGIBLE ASSETS

The components of intangible assets, all of which are finite-lived, were as follows:

 

(In millions)    Gross
Carrying
Amount
    Accumulated
Amortization
   

Net

Carrying
Amount

    Gross
Carrying
Amount
    Accumulated
Amortization
    Net
Carrying
Amount
 


                

December 31,

2011

   

June 30,

2011

 

Technology-based (a)

   $ 2,965      $ (2,012   $ 953      $ 2,356      $ (1,831   $ 525   

Marketing-related

     1,361        (122     1,239        113        (98     15   

Contract-based

     1,190        (990     200        1,068        (966     102   

Customer-related

     440        (251     189        326        (224     102   


 


 


 


 


 


Total

   $   5,956      $   (3,375   $   2,581      $   3,863      $   (3,119   $   744   
    


 


 


 


 


 


 

(a)

Technology-based intangible assets included $150 million and $179 million as of December 31, 2011 and June 30, 2011, respectively, of net carrying amount of software to be sold, leased, or otherwise marketed.

 

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Intangible assets amortization expense was $155 million and $264 million for the three and six months ended December 31, 2011, respectively, as compared with $126 million and $250 million for the three and six months ended December 31, 2010, respectively. Amortization of capitalized software was $28 million and $57 million for the three and six months ended December 31, 2011, respectively, and $30 million and $56 million for the three and six months ended December 31, 2010, respectively.

The following table outlines the estimated future amortization expense related to intangible assets held at December 31, 2011:

 

(In millions)       


Year Ending June 30,       

2012 (excluding the six months ended December 31, 2011)

   $ 284   

2013

     480   

2014

     314   

2015

     260   

2016

     216   

Thereafter

     1,027   


Total

   $   2,581   
    


NOTE 11    DEBT

As of December 31, 2011, the total carrying value and estimated fair value of our long-term debt, including convertible debt, were $11.9 billion and $13.1 billion, respectively. This is compared to a carrying value and estimated fair value of $11.9 billion and $12.1 billion, respectively, as of June 30, 2011. The estimated fair value is based on quoted prices for our publicly-traded debt as of December 31, 2011 and June 30, 2011, as applicable.

The components of long-term debt, the associated interest rates, and the semi-annual interest record and payment dates were as follows as of December 31, 2011:

 

Due Date    Face Value    

Stated
Interest

Rate

   

Effective
Interest

Rate

   

Interest

Record Date

    

Interest

Pay Date

    

Interest

Record Date

    

Interest

Pay Date

 


       (In millions                                                   

Notes

                                                           

September 27, 2013

   $ 1,000        0.875 %     1.000 %     March 15         March 27         September 15         September 27   

June 1, 2014

     2,000        2.950 %     3.049 %     May 15         June 1         November 15         December 1   

September 25, 2015

     1,750        1.625 %     1.795 %     March 15         March 25         September 15         September 25   

February 8, 2016

     750        2.500 %     2.642 %     February 1         February 8         August 1         August 8   

June 1, 2019

     1,000        4.200 %     4.379 %     May 15         June 1         November 15         December 1   

October 1, 2020

     1,000        3.000 %     3.137 %     March 15         April 1         September 15         October 1   

February 8, 2021

     500        4.000 %     4.082 %     February 1         February 8         August 1         August 8   

June 1, 2039

     750        5.200 %     5.240 %     May 15         June 1         November 15         December 1   

October 1, 2040

     1,000        4.500 %     4.567 %     March 15         April 1         September 15         October 1   

February 8, 2041

     1,000        5.300 %     5.361 %     February 1         February 8         August 1         August 8   


                                                  

Total

     10,750                                                      

Convertible Debt

                                                           

June 15, 2013

     1,250        0.000 %     1.849 %                                   

Total unamortized discount

     (68                                                   


                                                  

Total

   $ 11,932                                                      
    


                                                  

 

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The components of long-term debt, the associated interest rates, and the semi-annual interest record and payment dates were as follows as of June 30, 2011:

 

Due Date    Face Value    

Stated
Interest

Rate

   

Effective
Interest

Rate

   

Interest

Record Date

    

Interest

Pay Date

    

Interest

Record Date

    

Interest

Pay Date

 


       (In millions                                                   

Notes

                                                           

September 27, 2013

   $ 1,000        0.875 %     1.000 %     March 15         March 27         September 15         September 27   

June 1, 2014

     2,000        2.950 %     3.049 %     May 15         June 1         November 15         December 1   

September 25, 2015

     1,750        1.625 %     1.795 %     March 15         March 25         September 15         September 25   

February 8, 2016

     750        2.500 %     2.642 %     February 1         February 8         August 1         August 8   

June 1, 2019

     1,000        4.200 %     4.379 %     May 15         June 1         November 15         December 1   

October 1, 2020

     1,000        3.000 %     3.137 %     March 15         April 1         September 15         October 1   

February 8, 2021

     500        4.000 %     4.082 %     February 1         February 8         August 1         August 8   

June 1, 2039

     750        5.200 %     5.240 %     May 15         June 1         November 15         December 1   

October 1, 2040

     1,000        4.500 %     4.567 %     March 15         April 1         September 15         October 1   

February 8, 2041

     1,000        5.300 %     5.361 %     February 1         February 8         August 1         August 8   


                                                  

Total

     10,750                                                      

Convertible Debt

                                                           

June 15, 2013

     1,250        0.000 %     1.849 %                                   

Total unamortized discount

     (79                                                   


                                                  

Total

   $ 11,921                                                      
    


                                                  

Notes

The Notes are senior unsecured obligations and rank equally with our other unsecured and unsubordinated debt outstanding.

Convertible Debt

In June 2010, we issued $1.25 billion of zero coupon convertible unsecured debt due on June 15, 2013 in a private placement offering. Proceeds from the offering were $1.24 billion, net of fees and expenses, which were capitalized. Each $1,000 principal amount of notes is convertible into 29.94 shares of Microsoft common stock at a conversion price of $33.40 per share. As of December 31, 2011, the net carrying amount of our convertible debt was $1.2 billion and the unamortized discount was $28 million.

Prior to March 15, 2013, the notes will be convertible, only in certain circumstances, into cash and, if applicable, cash, shares of Microsoft’s common stock, or a combination thereof, at our election. On or after March 15, 2013, the notes will be convertible at any time. Upon conversion, we will pay cash up to the aggregate principal amount of the notes and pay or deliver cash, shares of our common stock or a combination of cash and shares of our common stock, at our election.

Because the convertible debt may be wholly or partially settled in cash, we are required to separately account for the liability and equity components of the notes in a manner that reflects our nonconvertible debt borrowing rate when interest costs are recognized in subsequent periods. The net proceeds of $1.24 billion were allocated between debt for $1.18 billion and stockholders’ equity for $58 million with the portion in stockholders’ equity representing the fair value of the option to convert the debt.

In connection with the issuance of the notes, we entered into capped call transactions with certain option counterparties who are initial purchasers of the notes or their affiliates. The capped call transactions are expected to reduce potential dilution of earnings per share upon conversion of the notes. Under the capped call transactions, we purchased from the option counterparties capped call options that in the aggregate relate to the total number of shares of our common stock underlying the notes, with a strike price equal to the conversion price of the notes and with a cap price equal to $37.16. The purchased capped calls were valued at $40 million and recorded to stockholders’ equity.

 

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NOTE 12    INCOME TAXES

Our effective tax rates were approximately 20% and 22% for the three months ended December 31, 2011 and 2010, respectively, and 20% and 23% for the six months ended December 31, 2011 and 2010, respectively. Our effective tax rate was lower than the U.S. federal statutory rate and prior year effective rates primarily due to a higher mix of earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico, which are subject to lower income tax rates.

Tax contingencies and other tax liabilities were $7.7 billion and $7.4 billion as of December 31, 2011 and June 30, 2011, respectively, and are included in other long-term liabilities. While we settled a portion of the I.R.S. audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, we remain under audit for these years. During the fourth quarter of fiscal year 2011, the I.R.S. completed its examination and issued a Revenue Agent’s Report (“RAR”) for the remaining unresolved items. We do not agree with the adjustments in the RAR, and we have filed a protest to initiate the administrative appeals process. The proposed adjustments are primarily related to transfer pricing and could have a significant impact on our financial statements if not resolved favorably. We do not believe it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months, as we do not believe the appeals process will be concluded within the next 12 months. We also continue to be subject to examination by the I.R.S. for tax years 2007 to 2011.

We are subject to income tax in many jurisdictions outside the U.S. Certain jurisdictions remain subject to examination for tax years 1996 to 2010, some of which are currently under audit by local tax authorities. The resolutions of these audits are not expected to be material to our financial statements.

NOTE 13    UNEARNED REVENUE

The components of unearned revenue were as follows:

 

(In millions)             


December 31,

2011

  

  

   

 

June 30,

2011

  

  

Volume licensing programs

   $   12,873      $   14,625   

Other

     2,461        2,495   


 


Total

   $ 15,334      $ 17,120   
    


 


Unearned revenue by segment was as follows:

 

(In millions)             


December 31,

2011

  

  

   

 

June 30,

2011

  

  

Windows & Windows Live Division

   $ 1,525      $ 1,782   

Server and Tools

     5,612        6,315   

Microsoft Business Division

     7,085        8,187   

Other segments

     1,112        836   


 


Total

   $   15,334      $   17,120   
    


 


Fiscal year 2011 amounts have been recast for the fiscal year 2012 movement of Forefront Protection for Office, an anti-malware solution, from Server and Tools to the Microsoft Business Division.

NOTE 14    COMMITMENTS AND GUARANTEES

Yahoo! Commercial Agreement

On December 4, 2009, we entered into a 10-year agreement with Yahoo! whereby Microsoft will provide the exclusive algorithmic and paid search platform for Yahoo! Web sites. Microsoft provided Yahoo! with revenue per search guarantees for a period of 18 months after implementation of the Microsoft search ads platform in each country, extended by an additional 12 months for the U.S. and Canada. These guarantees are calculated, paid, and adjusted periodically and are rate guarantees, not guarantees of search volume. We estimate the remaining cost of the revenue per search guarantees during the guarantee period could range up to $150 million. Microsoft also agreed to reimburse Yahoo! for certain costs of running algorithmic and paid search services prior to migration to Microsoft’s platform.

 

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Product Warranty

The changes in our aggregate product warranty liabilities, which are included in other current liabilities and other long-term liabilities on our balance sheets were as follows:

 

(In millions)   

Three Months Ended

December 31,

   

Six Months Ended

December 31,

 


       2011        2010        2011        2010   

Balance, beginning of period

   $ 166      $ 214      $ 172      $ 240   

Accruals for warranties issued

     19        19        31        32   

Settlements of warranty claims

     (18     (31     (36     (70


 


 


 


Balance, end of period

   $   167      $   202      $   167      $   202   
    


 


 


 


NOTE 15    CONTINGENCIES

Antitrust, Unfair Competition, and Overcharge Class Actions

A large number of antitrust and unfair competition class action lawsuits were filed against us in various state, federal, and Canadian courts on behalf of various classes of direct and indirect purchasers of our PC operating system and certain other software products. We obtained dismissals or reached settlements of all claims that have been made to date in the United States.

All settlements in the United States have received final court approval. Under the settlements, generally class members can obtain vouchers that entitle them to be reimbursed for purchases of a wide variety of platform-neutral computer hardware and software. The total value of vouchers that we may issue varies by state. We will make available to certain schools a percentage of those vouchers that are not issued or claimed (one-half to two-thirds depending on the state). The total value of vouchers we ultimately issue will depend on the number of class members who make claims and are issued vouchers. The maximum value of vouchers to be issued is approximately $2.7 billion. The actual costs of these settlements will be less than that maximum amount, depending on the number of class members and schools that are issued and redeem vouchers. We estimate the total cost to resolve all of the state overcharge class action cases will range between $1.9 billion and $2.0 billion. At December 31, 2011, we have recorded a liability related to these claims of approximately $524 million, which reflects our estimated exposure of $1.9 billion less payments made to date of approximately $1.4 billion mostly for vouchers, legal fees, and administrative expenses.

The three cases pending in British Columbia, Ontario, and Quebec, Canada have not been settled. In March 2010, the court in the British Columbia case certified it as a class action. On April 15, 2011, the British Columbia Court of Appeal reversed the class certification ruling and dismissed the case, holding that indirect purchasers do not have a claim. The plaintiffs have appealed to the Canadian Supreme Court. The other two actions have been stayed.

Other Antitrust Litigation and Claims

In November 2004, Novell, Inc. (“Novell”) filed a complaint in U.S. District Court for the District of Utah (later transferred to federal court in Maryland), asserting antitrust and unfair competition claims against us related to Novell’s ownership of WordPerfect and other productivity applications during the period between June 1994 and March 1996. In June 2005, the trial court granted our motion to dismiss four of six claims of the complaint. In March 2010, the trial court granted summary judgment in favor of Microsoft as to all remaining claims. The court of appeals reversed that ruling. Trial on the case took place in October 2011 and resulted in a mistrial because the jury was unable to reach a verdict. Microsoft expects to file a motion for judgment as a matter of law. The court has not set a new trial date.

Patent and Intellectual Property Claims

In 2003, we filed an action in U.S. District Court in California seeking a declaratory judgment that we do not infringe certain Alcatel-Lucent patents (although this action began before the merger of Alcatel and Lucent in 2006, for simplicity we refer to the post-merger entity of Alcatel-Lucent). In April 2008, a jury returned a verdict in Alcatel-Lucent’s favor in a

 

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trial on a consolidated group of one video and three user interface patents. The jury concluded that we had infringed two user interface patents and awarded $367 million in damages. In June 2008, the trial judge increased the amount of damages to $512 million to include $145 million of interest. We appealed that award. In December 2008, we entered into a settlement agreement resolving all other litigation pending between Microsoft and Alcatel-Lucent, leaving approximately $500 million remaining in dispute. In September 2009, the court of appeals affirmed the liability award but vacated the verdict and remanded the case to the trial court for a re-trial of the damages ruling, indicating the damages previously awarded were too high. Trial on the remanded damages claim was held in July 2011 and the jury awarded Alcatel-Lucent $70 million. We filed a motion for judgment as a matter of law, which the court granted in part, and reduced the judgment to $26 million, not including post-trial interest, which would have increased the judgment to approximately $41 million. Alcatel-Lucent appealed the court’s decision, and Microsoft cross-appealed. The parties have now entered into a confidential settlement agreement to resolve the matter.

In October 2003, Uniloc USA Inc. (“Uniloc”), a subsidiary of a Singapore-based company, filed a patent infringement suit in U.S. District Court in Rhode Island, claiming that product activation technology supporting Windows XP and certain other Microsoft programs violated a Uniloc patent. After we obtained a favorable summary judgment that we did not infringe any of the claims of this patent, the court of appeals vacated the trial court decision and remanded the case for trial. In April 2009, the jury returned a $388 million verdict against us, including a finding of willful infringement. In September 2009, the district court judge overturned the jury verdict, ruling that the evidence did not support the jury’s findings either that Microsoft infringed the patent or was willful. Uniloc appealed, and in January 2011 the court of appeals reversed the district court’s finding of non-infringement (thus reinstating the jury verdict of infringement) but affirmed the district court’s ruling that Microsoft was not willful and affirmed the district court’s grant of a new trial on damages. Uniloc’s petition for rehearing of the court of appeals’ decision as to damages was denied. A new trial on damages has been set for February 2012.

In October 2010, we filed suit against Motorola with the International Trade Commission (“ITC”) and in U.S. District Court in Washington for infringement of nine Microsoft patents by Motorola’s Android-based devices. Since then, Microsoft and Motorola have filed additional actions against each other in the ITC and federal courts in Washington, Wisconsin, Florida, California and Germany. Microsoft asserts Motorola’s Android-based devices violate 28 of its patents, and Motorola asserts various Microsoft products (including Windows, Windows Phone 7, Windows Mobile 6.5, Xbox, Bing Maps, Hotmail, Messenger, and Exchange Server) violate 24 Motorola patents. Microsoft also claims Motorola has breached its contractual commitments to the Institute of Electrical and Electronics Engineers and International Telecommunications Union to license identified patents related to wireless and video coding technologies under reasonable and non-discriminatory (“RAND”) terms and conditions. In the case originally filed in California, Motorola asserts that Microsoft breached contractual commitments to the SD Card Association to license two patents under RAND terms and conditions, and asserts federal antitrust and state unfair business practice claims. Trial in our ITC case took place in August 2011. In December 2011, the administrative law judge issued an initial determination that Motorola infringed one Microsoft patent, and recommended that the ITC issue a limited exclusion order against Motorola. The ITC’s ruling is expected in April 2012. Trial in Motorola’s ITC case is set for January 2012. All of the cases pending in Wisconsin, California and Florida, with the exception of one currently stayed case in Wisconsin, have been transferred to the Western District of Washington. The lawsuits filed in Germany by Motorola and Microsoft all allege patent infringement. A hearing in one of our German actions against Motorola took place in December 2011. Additional hearings are scheduled on Microsoft’s claims against Motorola in Germany in February, March, April, and June 2012. Motorola’s German actions against Microsoft are scheduled for trial in January and March 2012.

In addition to these cases, there are approximately 60 other patent infringement cases pending against Microsoft.

Other

We also are subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact on our financial statements, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future.

As of December 31, 2011, we had accrued aggregate liabilities of $411 million in other current liabilities and $295 million in other long-term liabilities for all of the contingent matters described in this note. While we intend to vigorously defend these matters, adverse outcomes that we estimate could reach approximately $560 million in aggregate beyond recorded amounts are reasonably possible. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact on our financial statements for the period in which the effects become reasonably estimable.

 

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NOTE 16    STOCKHOLDERS’ EQUITY

Share Repurchases

We repurchased the following shares of common stock during the periods presented:

 

(In millions)    Three Months Ended
December 31,
    Six Months Ended
December 31,
 


     2011     2010     2011     2010  

Shares of common stock repurchased

     39        188        78        351   

Value of common stock repurchased

   $   1,000      $   5,000      $   2,000      $   9,000   


We repurchased all shares with cash resources. As of December 31, 2011, approximately $10.2 billion remained of our $40.0 billion repurchase program that we announced on September 22, 2008. The repurchase program expires September 30, 2013 but may be suspended or discontinued at any time without notice.

Dividends

Our Board of Directors declared the following dividends during the periods presented:

 

Declaration Date    Dividend
Per Share
    Record Date      Total Amount     Payment Date  


                  (in millions)        
Fiscal Year 2012                          

September 20, 2011

   $ 0.20        November 17, 2011       $   1,683        December 8, 2011   

December 14, 2011

   $ 0.20        February 16, 2012       $ 1,676        March 8, 2012   
Fiscal Year 2011                          

September 21, 2010

   $ 0.16        November 18, 2010       $ 1,363        December 9, 2010   

December 15, 2010

   $   0.16        February 17, 2011       $ 1,349        March 10, 2011   


The estimate of the amount to be paid as a result of the December 14, 2011 declaration was included in other current liabilities as of December 31, 2011.

NOTE 17    SEGMENT INFORMATION

In its operation of the business, management, including our chief operating decision maker, the Company’s Chief Executive Officer, reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. The segment information within this note is reported on that basis. Our five segments are Windows & Windows Live Division; Server and Tools; Online Services Division; Microsoft Business Division; and Entertainment and Devices Division.

Due to the integrated structure of our business, certain revenue earned and costs incurred by one segment may benefit other segments. Revenue on certain contracts may be allocated among the segments based on the relative value of the underlying products and services. Costs that are identifiable are allocated to the segments that benefit to incent cross-collaboration among our segments so that one segment is not solely burdened by the cost of a mutually beneficial activity. Allocated costs may include those relating to development and marketing of products and services from which multiple segments benefit, or those costs relating to services performed by one segment on behalf of other segments. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated.

In addition, certain costs incurred at a corporate level that are identifiable and that benefit our segments are allocated to them. These allocated costs include costs of: field selling; employee benefits; shared facilities services; and customer service and support. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. Certain other corporate-level activity is not allocated to our segments, including costs of: broad-based sales and marketing; product support services; human resources; legal; finance; information technology; corporate development and procurement activities; research and development; legal settlements and contingencies; and employee severance.

 

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We have recast certain prior period amounts within this note to conform to the way we internally managed and monitored segment performance during the current fiscal year, including moving Forefront Protection for Office, an anti-malware solution, from Server and Tools to the Microsoft Business Division, as well as conforming management reporting and U.S. GAAP reporting for stock-based compensation.

Segment revenue and operating income (loss) were as follows during the periods presented:

 

(In millions)    Three Months Ended
December 31,
    Six Months Ended
December 31,
 


     2011     2010     2011     2010