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, 2013

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, 2014  


Common Stock, $0.00000625 par value per share

     8,300,723,725 shares   

 



Table of Contents

MICROSOFT CORPORATION

FORM 10-Q

For the Quarter Ended December 31, 2013

INDEX

 

                 Page  

PART I.

  FINANCIAL INFORMATION        
    Item 1.   Financial Statements        
        a)    Income Statements for the Three and Six Months Ended December 31, 2013 and 2012     3   
        b)    Comprehensive Income Statements for the Three and Six Months Ended December 31, 2013 and 2012     4   
        c)    Balance Sheets as of December 31, 2013 and June 30, 2013     5   
        d)    Cash Flows Statements for the Three and Six Months Ended December 31, 2013 and 2012     6   
        e)    Stockholders’ Equity Statements for the Three and Six Months Ended December 31, 2013 and 2012     7   
        f)    Notes to Financial Statements     8   
        g)    Report of Independent Registered Public Accounting Firm     31   
    Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations     32   
    Item 3.   Quantitative and Qualitative Disclosures About Market Risk     51   
    Item 4.   Controls and Procedures     52   

PART II.  

  OTHER INFORMATION        
    Item 1.   Legal Proceedings     52   
    Item 1A.   Risk Factors     52   
    Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds     60   
    Item 6.   Exhibits     61   

SIGNATURE

    62   

 

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,
 


     2013     2012     2013     2012  

Revenue

   $   24,519      $   21,456      $   43,048      $   37,464   

Cost of revenue

     8,284        5,692        13,398        9,860   


 


 


 


Gross margin

     16,235        15,764        29,650        27,604   

Operating expenses:

                                

Research and development

     2,748        2,528        5,515        4,988   

Sales and marketing

     4,283        4,309        7,587        7,254   

General and administrative

     1,235        1,156        2,245        2,283   


 


 


 


Total operating expenses

     8,266        7,993        15,347        14,525   


 


 


 


Operating income

     7,969        7,771        14,303        13,079   

Other income (expense)

     (91     (1     (17     225   


 


 


 


Income before income taxes

     7,878        7,770        14,286        13,304   

Provision for income taxes

     1,320        1,393        2,484        2,461   


 


 


 


Net income

   $ 6,558      $ 6,377      $ 11,802      $ 10,843   
    


 


 


 


Earnings per share:

                                

Basic

   $ 0.79      $ 0.76      $ 1.42      $ 1.29   

Diluted

   $ 0.78      $ 0.76      $ 1.40      $ 1.28   

Weighted average shares outstanding:

                                

Basic

     8,326        8,393        8,333        8,395   

Diluted

     8,395        8,444        8,423        8,480   

Cash dividends declared per common share

   $ 0.28      $ 0.23      $ 0.56      $ 0.46   


See accompanying notes.

 

3


Table of Contents

PART I

Item 1

 

COMPREHENSIVE INCOME STATEMENTS

 

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


     2013     2012     2013     2012  

Net income

   $     6,558      $     6,377      $   11,802      $   10,843   

Other comprehensive income (loss):

                                

Net unrealized gains (losses) on derivatives (net of tax effects of $1 , $(5), $(2) , and $(29))

     43        (9     17        (54

Net unrealized gains on investments (net of tax effects of $245 , $103, $737 , and $251)

     482        192        1,434        466   

Translation adjustments and other (net of tax effects of $11 , $2, $44 and $92)

     21        3        83        172   


 


 


 


Other comprehensive income

     546        186        1,534        584   


 


 


 


Comprehensive income

   $ 7,104      $ 6,563      $ 13,336      $ 11,427   
    


 


 


 


See accompanying notes.

 

4


Table of Contents

PART I

Item 1

 

BALANCE SHEETS

 

(In millions) (Unaudited)             


December 31,

2013

    June 30,
2013
 

Assets

                

Current assets:

                

Cash and cash equivalents

   $ 10,059      $ 3,804   

Short-term investments (including securities loaned of $685 and $579)

     73,885        73,218   


 


Total cash, cash equivalents, and short-term investments

     83,944        77,022   

Accounts receivable, net of allowance for doubtful accounts of $316 and $336

     15,986        17,486   

Inventories

     1,594        1,938   

Deferred income taxes

     1,328        1,632   

Other

     4,018        3,388   


 


Total current assets

     106,870        101,466   

Property and equipment, net of accumulated depreciation of $13,686 and $12,513

     11,567        9,991   

Equity and other investments

     14,607        10,844   

Goodwill

     14,680        14,655   

Intangible assets, net

     2,945        3,083   

Other long-term assets

     2,874        2,392   


 


Total assets

   $   153,543      $   142,431   
    


 


Liabilities and stockholders’ equity

                

Current liabilities:

                

Accounts payable

   $ 5,398      $ 4,828   

Short-term debt

     300        0   

Current portion of long-term debt

     2,000        2,999   

Accrued compensation

     3,169        4,117   

Income taxes

     591        592   

Short-term unearned revenue

     17,616        20,639   

Securities lending payable

     748        645   

Other

     3,920        3,597   


 


Total current liabilities

     33,742        37,417   

Long-term debt

     20,676        12,601   

Long-term unearned revenue

     1,858        1,760   

Deferred income taxes

     2,377        1,709   

Other long-term liabilities

     9,790        10,000   


 


Total liabilities

     68,443        63,487   


 


Commitments and contingencies

                

Stockholders’ equity:

                

Common stock and paid-in capital—shares authorized 24,000; outstanding 8,300 and 8,328

     67,476        67,306   

Retained earnings

     14,347        9,895   

Accumulated other comprehensive income

     3,277        1,743   


 


Total stockholders’ equity

     85,100        78,944   


 


Total liabilities and stockholders’ equity

   $ 153,543      $ 142,431   
    


 


See accompanying notes.

 

5


Table of Contents

PART I

Item 1

 

CASH FLOWS STATEMENTS

 

(In millions) (Unaudited)   

Three Months Ended

December 31,

   

Six Months Ended

December 31,

 


     2013     2012     2013     2012  

Operations

                                

Net income

   $ 6,558      $ 6,377      $ 11,802      $ 10,843   

Adjustments to reconcile net income to net cash from operations:

                                

Depreciation, amortization, and other

     1,261        1,009        2,215        1,719   

Stock-based compensation expense

     591        603        1,226        1,206   

Net recognized losses on investments and derivatives

     47        22        140        33   

Excess tax benefits from stock-based compensation

     (20     (9     (225     (186

Deferred income taxes

     (176     140        228        178   

Deferral of unearned revenue

     9,845        10,737        17,281        18,946   

Recognition of unearned revenue

       (10,578       (10,483       (20,255       (19,253

Changes in operating assets and liabilities:

                                

Accounts receivable

     (4,875     (4,488     1,742        1,668   

Inventories

     1,029        (33     362        (506

Other current assets

     (95     150        (651     (235

Other long-term assets

     (315     (80     (396     (313

Accounts payable

     602        685        326        118   

Other current liabilities

     388        168        (867     (1,119

Other long-term liabilities

     151        (18     (310     165   


 


 


 


Net cash from operations

     4,413        4,780        12,618        13,264   


 


 


 


Financing

                                

Short-term debt repayments, maturities less than 90 days, net

     (712     0        0        0   

Proceeds from issuance of debt

     8,262        2,232        8,850        2,232   

Repayments of debt

     (588     0        (1,588     0   

Common stock issued

     117        145        320        562   

Common stock repurchased

     (2,113     (1,658     (4,301     (3,290

Common stock cash dividends paid

     (2,332     (1,933     (4,248     (3,609

Excess tax benefits from stock-based compensation

     20        9        225        186   

Other

     (39     (16     (39     (16


 


 


 


Net cash from (used in) financing

     2,615        (1,221     (781     (3,935


 


 


 


Investing

                                

Additions to property and equipment

     (1,732     (930     (2,963     (1,533

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

     (139     (311     (154     (1,456

Purchases of investments

     (13,126     (10,074     (27,894     (30,212

Maturities of investments

     1,451        1,989        1,798        3,248   

Sales of investments

     12,354        7,126        23,471        20,433   

Securities lending payable

     167        (393     103        (792


 


 


 


Net cash used in investing

     (1,025     (2,593     (5,639     (10,312


 


 


 


Effect of exchange rates on cash and cash equivalents

     33        15        57        62   


 


 


 


Net change in cash and cash equivalents

     6,036        981        6,255        (921

Cash and cash equivalents, beginning of period

     4,023        5,036        3,804        6,938   


 


 


 


Cash and cash equivalents, end of period

   $ 10,059      $ 6,017      $ 10,059      $ 6,017   
    


 


 


 


See accompanying notes.

 

6


Table of Contents

PART I

Item 1

 

STOCKHOLDERS’ EQUITY STATEMENTS

 

(In millions) (Unaudited)   

Three Months Ended

December 31,

   

Six Months Ended

December 31,

 


     2013     2012     2013     2012  

Common stock and paid-in capital

                                

Balance, beginning of period

   $   67,230      $   66,084      $   67,306      $   65,797   

Common stock issued

     117        145        320        552   

Common stock repurchased

     (486     (507     (1,607     (1,398

Stock-based compensation expense

     591        603        1,226        1,206   

Stock-based compensation income tax benefits

     21        5        226        172   

Other, net

     3        4        5        5   


 


 


 


Balance, end of period

     67,476        66,334        67,476        66,334   


 


 


 


Retained earnings (deficit)

                                

Balance, beginning of period

     11,680        932        9,895        (856

Net income

     6,558        6,377        11,802        10,843   

Common stock cash dividends

     (2,319     (1,922     (4,656     (3,859

Common stock repurchased

     (1,572     (1,151     (2,694     (1,892


 


 


 


Balance, end of period

     14,347        4,236        14,347        4,236   


 


 


 


Accumulated other comprehensive income

                                

Balance, beginning of period

     2,731        1,820        1,743        1,422   

Other comprehensive income

     546        186        1,534        584   


 


 


 


Balance, end of period

     3,277        2,006        3,277        2,006   


 


 


 


Total stockholders’ equity

   $ 85,100      $ 72,576      $ 85,100      $ 72,576   
    


 


 


 


See accompanying notes.

 

7


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, comprehensive 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 2013 Form 10-K and Form 8-K filed with the U.S. Securities and Exchange Commission on July 30, 2013 and November 26, 2013, respectively.

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 are able to 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 of estimates include: loss contingencies; product warranties; the fair value of, and/or potential goodwill impairment for, our reporting units; product life cycles; useful lives of our tangible and intangible assets; allowances for doubtful accounts; allowances for product returns; the market value of our inventory; and stock-based compensation forfeiture rates. Examples of assumptions include: the elements comprising a software arrangement, including the distinction between upgrades or 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; and determining when investment impairments are other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions.

Recasting of Certain Prior Period Information

During the first quarter of fiscal year 2014, we changed our organizational structure as part of our transformation to a devices and services company. As a result of these changes, information that our chief operating decision maker regularly reviews for purposes of allocating resources and assessing performance changed. Therefore, beginning in fiscal year 2014, we are reporting our financial performance based on our new segments described in Note 16 – Segment Information. We have recast certain prior period amounts to conform to the way we internally manage and monitor segment performance during fiscal year 2014. This change impacted Note 8 – Goodwill, Note 12 – Unearned Revenue, and Note 16 – Segment Information, with no impact on consolidated net income or cash flows.

Recent Accounting Guidance

Recently adopted accounting guidance

In December 2011, the Financial Accounting Standards Board (“FASB”) issued guidance enhancing disclosure requirements about the nature of an entity’s right to offset and related arrangements associated with its financial 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. In January 2013, the FASB clarified that the scope of this guidance applies to derivatives, repurchase agreements, and securities lending arrangements that are either offset or subject to an enforceable master netting arrangement, or similar agreements. We adopted this new guidance beginning July 1, 2013. Adoption of this new guidance resulted only in changes to the presentation of Note 5 – Derivatives.

 

8


Table of Contents

PART I

Item 1

 

In February 2013, the FASB issued guidance on disclosure requirements for items reclassified out of accumulated other comprehensive income (“AOCI”). This new guidance requires entities to present (either on the face of the income statement or in the notes to financial statements) the effects on the line items of the income statement for amounts reclassified out of AOCI. We adopted this new guidance beginning July 1, 2013. Adoption of this new guidance resulted only in changes to the presentation of Note 15 – Accumulated Other Comprehensive Income.

Recent accounting guidance not yet adopted

In March 2013, the FASB issued guidance on a parent’s accounting for the cumulative translation adjustment upon derecognition of a subsidiary or group of assets within a foreign entity. This new guidance requires that the parent release any related cumulative translation adjustment into net income only if the sale or transfer results in the complete or substantially complete liquidation of the foreign entity in which the subsidiary or group of assets had resided. The new guidance will be effective for us beginning July 1, 2014. 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 and 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,

 


     2013     2012     2013     2012  

Net income available for common shareholders (A)

   $     6,558      $     6,377      $   11,802      $   10,843   

Weighted average outstanding shares of common stock (B)

     8,326        8,393        8,333        8,395   

Dilutive effect of stock-based awards

     69        51        90        85   


 


 


 


Common stock and common stock equivalents (C)

     8,395        8,444        8,423        8,480   
    


 


 


 


Earnings Per Share                         

Basic (A/B)

   $ 0.79      $ 0.76      $ 1.42      $ 1.29   

Diluted (A/C)

   $ 0.78      $ 0.76      $ 1.40      $ 1.28   


Anti-dilutive stock-based awards excluded from the calculations of diluted EPS were immaterial during the periods presented.

NOTE 3 — OTHER INCOME (EXPENSE)

The components of other income (expense) were as follows:

 

(In millions)   

Three Months Ended

December 31,

   

Six Months Ended

December 31,

 


     2013     2012     2013     2012  

Dividends and interest income

   $ 219      $ 166      $ 398      $ 325   

Interest expense

       (135       (105       (253       (200

Net recognized gains on investments

     70        43        63        28   

Net losses on derivatives

     (117     (65     (203     (61

Net gains (losses) on foreign currency remeasurements

     (17     (7     9        (36

Other

     (111     (33     (31     169   


 


 


 


Total

   $ (91   $ (1   $ (17   $ 225   
    


 


 


 


 

9


Table of Contents

PART I

Item 1

 

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

 

(In millions)   

Three Months Ended

December 31,

   

Six Months Ended

December 31,

 


     2013     2012     2013     2012  

Other-than-temporary impairments of investments

   $ (30   $ (40   $ (66   $   (130

Realized gains from sales of available-for-sale securities

        144           109        258        210   

Realized losses from sales of available-for-sale securities

     (44     (26       (129     (52


 


 


 


Total

   $ 70      $ 43      $ 63      $ 28   
    


 


 


 


NOTE 4 — INVESTMENTS

Investment Components

The components of investments, including associated derivatives but excluding held-to-maturity investments, 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, 2013                                           

Cash

   $ 2,747      $ 0      $ 0      $ 2,747      $ 2,747      $ 0      $ 0   

Mutual funds

     766        0        0        766        766        0        0   

Commercial paper

     390        0        0        390        141        249        0   

Certificates of deposit

     979        0        0        979        771        208        0   

U.S. government and agency securities

     60,824        82        (85     60,821        452        60,369        0   

Foreign government bonds

     8,654        92        (44     8,702        5,169        3,533        0   

Mortgage-backed securities

     1,244        40        (18     1,266        0        1,266        0   

Corporate notes and bonds

     7,734        233        (37     7,930        13        7,917        0   

Municipal securities

     302        25        (3     324        0        324        0   

Common and preferred stock

     6,783        4,792        (118     11,457        0        0        11,457   

Other investments

     1,169        0        0        1,169        0        19        1,150   


 


 


 


 


 


 


Total

   $   91,592      $   5,264      $   (305   $   96,551      $   10,059      $   73,885      $   12,607   
    


 


 


 


 


 


 


 

(In millions)    Cost Basis    

Unrealized

Gains

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


June 30, 2013                                           

Cash

   $ 1,967      $ 0      $ 0      $ 1,967      $ 1,967      $ 0      $ 0   

Mutual funds

     868        0        0        868        868        0        0   

Commercial paper

     603        0        0        603        214        389        0   

Certificates of deposit

     994        0        0        994        609        385        0   

U.S. government and agency securities

     64,934        47        (84     64,897        146        64,751        0   

Foreign government bonds

     900        16        (41     875        0        875        0   

Mortgage-backed securities

     1,258        43        (13     1,288        0        1,288        0   

Corporate notes and bonds

     4,993        169        (40     5,122        0        5,122        0   

Municipal securities

     350        36        (1     385        0        385        0   

Common and preferred stock

     6,931        2,938        (281     9,588        0        0        9,588   

Other investments

     1,279        0        0        1,279        0        23        1,256   


 


 


 


 


 


 


Total

   $   85,077      $   3,249      $   (460   $   87,866      $     3,804      $   73,218      $   10,844   
    


 


 


 


 


 


 


 

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In addition to the investments in the table above, we also own certain corporate notes that were purchased in connection with our agreement to lend $2.0 billion to the group that completed their acquisition of Dell on October 29, 2013. These corporate notes are classified as held-to-maturity investments and are included in equity and other investments on the balance sheet. As of December 31, 2013, the amortized cost and recorded basis of these corporate notes was $2.0 billion, while their estimated fair value was $1.9 billion and associated gross unrecognized holding losses were $132 million.

As of December 31, 2013 and June 30, 2013, the recorded bases of common and preferred stock that are restricted for more than one year or are not publicly traded were $450 million and $395 million, respectively. These investments are carried at cost and are reviewed quarterly for indicators of other-than-temporary impairment. It is not practicable for us to reliably estimate the fair value of these investments.

Unrealized Losses on Investments

Investments, excluding those held-to-maturity, 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, 2013                                     

U.S. government and agency securities

   $ 4,193      $ (85   $ 0      $ 0      $ 4,193      $ (85

Foreign government bonds

     741        (32     30        (12     771        (44

Mortgage-backed securities

     430        (14     66        (4     496        (18

Corporate notes and bonds

     1,494        (36     18        (1     1,512        (37

Municipal securities

     42        (3     0        0        42        (3

Common and preferred stock

     590        (72     273        (46     863        (118


 


 


 


 


 


Total

   $   7,490      $   (242   $   387      $   (63   $   7,877      $   (305
    


 


 


 


 


 


 

     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, 2013                                     

U.S. government and agency securities

   $ 2,208      $ (84   $ 0      $ 0      $ 2,208      $ (84

Foreign government bonds

     589        (18     69        (23     658        (41

Mortgage-backed securities

     357        (12     39        (1     396        (13

Corporate notes and bonds

     1,142        (38     27        (2     1,169        (40

Municipal securities

     44        (1     0        0        44        (1

Common and preferred stock

     1,166        (168     409        (113     1,575        (281


 


 


 


 


 


Total

   $   5,506      $   (321   $   544      $   (139   $   6,050      $   (460
    


 


 


 


 


 


As of December 31, 2013, the fair value of our held-to-maturity investments that have been in an unrecognized loss position for less than 12 months was $1.9 billion. The associated unrealized loss was $132 million. As of December 31, 2013, we did not hold any held-to-maturity investments that have been in an unrecognized loss position for 12 months or greater.

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, 2013.

 

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Debt Investment Maturities

 

(In millions)    Cost Basis    

Estimated

Fair Value

 


December 31, 2013             

Due in one year or less

   $   29,401      $   29,480   

Due after one year through five years

     44,372        44,505   

Due after five years through 10 years

     4,633        4,670   

Due after 10 years

     1,721        1,757   


 


Total (a)

   $ 80,127      $ 80,412   
    


 


 

(a)

Excludes held-to-maturity investments due October 31, 2023 with a cost basis and estimated fair value at December 31, 2013 of $2.0 billion and $1.9 billion, respectively.

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. dollar 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, 2013 and June 30, 2013, the total notional amounts of these foreign exchange contracts sold were $4.3 billion and $5.1 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, 2013 and June 30, 2013, the total notional amounts of these foreign exchange contracts sold were $1.8 billion and $407 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, 2013, the total notional amounts of these foreign exchange contracts purchased and sold were $4.6 billion and $6.9 billion, respectively. As of June 30, 2013, the total notional amounts of these foreign exchange contracts purchased and sold were $5.0 billion and $7.9 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, 2013, the total notional amounts of equity contracts purchased and sold for managing market price risk were $1.6 billion and $1.6 billion, respectively, of which $362 million and $420 million, respectively, were designated as hedging instruments. As of June 30, 2013, the total notional amounts of equity contracts purchased and sold for managing market price risk were $898 million and $1.0 billion, respectively, none of which were designated as hedging instruments.

In connection with our agreement to purchase substantially all of the Devices & Services business of Nokia Corporation (“Nokia”), on September 23, 2013, we provided to Nokia 1.5 billion ($2.0 billion) of financing in the form of convertible notes, which we have recorded as short-term investments. See further discussion in Note 13 – Contingencies. The total notional amount of derivatives related to the Nokia convertible notes was $2.1 billion as of December 31, 2013. See Note 6 – Fair Value Measurements for additional details.

 

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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, 2013, the total notional amounts of fixed-interest rate contracts purchased and sold were $3.0 billion and $776 million, respectively. As of June 30, 2013, the total notional amounts of fixed-interest rate contracts purchased and sold were $1.1 billion and $809 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, 2013 and June 30, 2013, the total notional derivative amounts of mortgage contracts purchased were $1.0 billion and $1.2 billion, 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, 2013, the total notional amounts of credit contracts purchased and sold were $506 million and $470 million, respectively. As of June 30, 2013, the total notional amounts of credit contracts purchased and sold were $377 million and $501 million, respectively.

Commodity

We use broad-based commodity exposures to enhance portfolio returns and to facilitate portfolio diversification. We use swaps, 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, 2013, the total notional amounts of commodity contracts purchased and sold were $1.3 billion and $338 million, respectively. As of June 30, 2013, the total notional amounts of commodity contracts purchased and sold were $1.2 billion and $249 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 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, 2013, 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 gains (losses) are recognized in earnings in the periods of change together with the offsetting losses (gains) 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 gains (losses) on the derivatives 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

 

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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.

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 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:

 

                        December 31, 2013            June 30, 2013  
    


 


            Assets     Liabilities            Assets     Liabilities  
    


 


 


 


(In millions)   

Short-term
Investments

   

Other

Current
Assets

    Equity and
Other
Investments
    Other
Current
Liabilities
    Other
Long-term
Liabilities
   

Short-term
Investments

    Other
Current
Assets
    Other
Current
Liabilities
 


Non-designated Hedge Derivatives                                       

Foreign exchange contracts

             $ 33      $ 81      $ 0      $ (67   $ 0                $ 41      $ 87      $ (63

Equity contracts

              166        0        0        (17     0                 157        0        (9

Interest rate contracts

              19        0        0        (10     0                 18        0        (45

Credit contracts

              25        0        0        (17     0                 19        0        (17

Commodity contracts

              4        0        0        (1     0                 3        0        (1


 


 


 


 


          


 


 


Total

            $   247      $     81      $ 0      $   (112   $ 0               $   238      $     87      $   (135


 


 


 


 


          


 


 


Designated Hedge Derivatives                                       

Foreign exchange contracts

            $ 86      $ 90      $ 0      $ (1   $ 0               $ 9      $ 167      $ 0   

Equity contracts

              0        0        35        (45     (26              0        0        0   


 


 


 


 


          


 


 


Total

            $ 86      $ 90      $     35      $ (46   $     (26            $ 9      $ 167      $ 0   


 


 


 


 


          


 


 


Total gross amounts of derivatives

            $ 333      $ 171      $ 35      $ (158   $ (26            $ 247      $ 254      $ (135
      


 


 


 


 


          


 


 


Gross derivatives either offset or subject to an enforceable master netting agreement

            $ 187      $ 171      $ 35      $ (151   $ (26            $ 105      $ 254      $ (97

Gross amounts offset in the balance sheet

              (63     (52     (35     136        14                 (72     (9     80   


 


 


 


 


          


 


 


Net amounts presented in the balance sheet

            $ 124      $ 119      $ 0      $ (15   $ (12            $ 33      $ 245      $ (17

Gross amounts not offset in the balance sheet

              0        0        0        0        0                 0        0        0   


 


 


 


 


          


 


 


Net amount

            $ 124      $ 119      $ 0      $ (15   $ (12            $ 33      $ 245      $ (17
             


 


 


 


 


          


 


 


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

 

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Fair-Value Hedge Gains (Losses)

We recognized in other income (expense) 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,

 


     2013     2012     2013     2012  

Foreign Exchange Contracts

                                

Derivatives

   $ 73      $ 35      $ 59      $ 23   

Hedged items

       (74       (35       (61       (21


 


 


 


Total amount of ineffectiveness

   $ (1   $ 0      $ (2   $ 2   
    


 


 


 


Equity Contracts

                                

Derivatives

   $ (10   $ 0      $ (10   $ 0   

Hedged items

     10        0        10        0   


 


 


 


Total amount of ineffectiveness

   $ 0      $ 0      $ 0      $ 0   
    


 


 


 


Amount of equity contracts excluded from effectiveness assessment

   $ (26   $ 0      $ (26   $ 0   


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,

 


     2013     2012     2013     2012  

Effective Portion

                                

Gains (losses) recognized in OCI (net of tax effects of $2 , $7, $0 and $(5))

   $ 67      $ 13      $ 59      $ (10

Gains reclassified from AOCI into revenue

     25        34        44        69   

Amount Excluded from Effectiveness Assessment and Ineffective Portion

                                

Losses recognized in other income (expense)

         (40         (36       (120       (107


We estimate that $82 million of net derivative gains included in OCI at December 31, 2013 will be reclassified into earnings within the following 12 months. No significant amounts of gains (losses) were reclassified from AOCI into earnings as a result of forecasted transactions that failed to occur during the three and six months ended December 31, 2013.

 

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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,

 


     2013     2012     2013     2012  

Foreign exchange contracts

   $ 60      $   (12   $ 74      $   (25

Equity contracts

       (41     15          (46     17   

Interest-rate contracts

     (13     1        0        19   

Credit contracts

     4        (2     3        (9

Commodity contracts

     0        (45     11        21   


 


 


 


Total

   $ 10      $ (43   $ 42      $ 23   
    


 


 


 


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. government securities, 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, credit spreads, 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, common and preferred stock, mortgage-backed securities, U.S. agency securities, foreign government bonds, 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 and goodwill when it is recorded at fair value due to an impairment charge. We value the Level 3 corporate bonds using internally developed valuation models, inputs to which include interest rate curves, credit spreads, stock prices, volatilities, and probability-weighted scenarios. Unobservable inputs used in all of these models are significant to the fair values of the assets and liabilities.

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.

Our other current financial assets and our current financial liabilities have fair values that approximate their carrying values.

 

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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 (a)      

 

Gross Fair

Value

  

  

    Netting (b)      
 
Net Fair
Value
  
  


December 31, 2013                                     

Assets

                                                

Mutual funds

   $ 766      $ 0      $ 0      $ 766      $ 0      $ 766   

Commercial paper

     0        390        0        390        0        390   

Certificates of deposit

     0        979        0        979        0        979   

U.S. government and agency securities

     58,963        1,858        0        60,821        0        60,821   

Foreign government bonds

     354        8,261        0        8,615        0        8,615   

Mortgage-backed securities

     0        1,267        0        1,267        0        1,267   

Corporate notes and bonds

     0        5,662        2,066        7,728        0        7,728   

Municipal securities

     0        324        0        324        0        324   

Common and preferred stock

     9,544        1,487        12        11,043        0        11,043   

Derivatives

     13        480        46        539        (150     389   


 


 


 


 


 


Total

   $   69,640      $   20,708      $   2,124      $   92,472      $   (150   $   92,322   
    


 


 


 


 


 


Liabilities

                                                

Derivatives and other

   $ 14      $ 99      $ 71      $ 184      $ (150   $ 34   


 

(In millions)

     Level 1        Level 2        Level 3           

 

Gross Fair

Value

  

  

    Netting (b)      
 
Net Fair
Value
  
  


June 30, 2013                                     

Assets

                                                

Mutual funds

   $ 868      $ 0      $ 0      $ 868      $ 0      $ 868   

Commercial paper

     0        603        0        603        0        603   

Certificates of deposit

     0        994        0        994        0        994   

U.S. government and agency securities

     62,237        2,664        0        64,901        0        64,901   

Foreign government bonds

     9        851        0        860        0        860   

Mortgage-backed securities

     0        1,311        0        1,311        0        1,311   

Corporate notes and bonds

     0        4,915        19        4,934        0        4,934   

Municipal securities

     0        385        0        385        0        385   

Common and preferred stock

     8,470        717        5        9,192        0        9,192   

Derivatives

     12        489        0        501        (81     420   


 


 


 


 


 


Total

   $   71,596      $   12,929      $   24      $   84,549      $   (81   $   84,468   
    


 


 


 


 


 


Liabilities

                                                

Derivatives and other

   $ 14      $ 121      $ 0      $ 135      $ (80   $ 55   


 

(a)

Level 3 assets at December 31, 2013 primarily comprised €1.5 billion principal amount of Nokia convertible notes. The valuation of these notes considers the probability of closing our purchase of Nokia’s Devices & Services business as well as an analysis of market comparable transactions and management assumptions. The probability-weighted scenarios are considered significant unobservable inputs used in the fair value measurement of both the convertible notes and the embedded derivative. Significant changes in these probabilities in isolation would significantly alter the fair value measurement for both the notes and the embedded derivative.

 

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(b)

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.

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,

2013

    June 30,
2013
 

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

   $   92,322      $   84,468   

Cash

     2,747        1,967   

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

     450        395   

Other investments measured at fair value on a nonrecurring basis

     1,150        1,256   

Less derivative net assets classified as other current assets

     (119     (213

Other

     1        (7


 


Recorded basis of investment components (a)

   $ 96,551      $ 87,866   
    


 


 

(a)

Excludes held-to-maturity investments recorded at amortized cost and measured at fair value on a nonrecurring basis.

Financial Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

During the three and six months ended December 31, 2013 and 2012, we did not record any material other-than-temporary impairments on financial 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,

2013

    June 30,
2013
 

Raw materials

   $ 389      $ 328   

Work in process

     80        201   

Finished goods

     1,125        1,409   


 


Total

   $   1,594      $   1,938   
    


 


 

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NOTE 8 — GOODWILL

Changes in the carrying amount of goodwill were as follows:

 

(In millions)   

September 30,

2013

   

Acquisitions

    Other     December 31,
2013
 


Devices and Consumer            

   Licensing    $ 867                $ 0      $ 1                $ 868   
    

Hardware

     1,680                 0        8                 1,688   
    

Other

     738                 0        0                 738   


          


 


          


    

Total Devices and Consumer

   $ 3,285               $ 0      $ 9               $ 3,294   


          


 


          


Commercial

   Licensing    $ 10,071               $ 2      $   (13            $ 10,060   
    

Other

     1,311                 15        0                 1,326   


          


 


          


    

Total Commercial

   $ 11,382               $ 17      $ (13              11,386   


          


 


          


Total goodwill

        $   14,667               $   17      $ (4            $   14,680   
    


          


 


          


 

(In millions)        

June 30,

2013

   

Acquisitions

    Other     December 31,
2013
 


Devices and Consumer            

   Licensing    $ 866                $ 0      $ 2                $ 868   
    

Hardware

     1,689                 0          (1              1,688   
    

Other

     738                 0        0                 738   


          


 


          


    

Total Devices and Consumer

   $ 3,293               $ 0      $ 1               $ 3,294   


          


 


          


Commercial

   Licensing    $ 10,051               $ 2      $ 7               $ 10,060   
    

Other

     1,311                 15        0                 1,326   


          


 


          


    

Total Commercial

   $ 11,362               $ 17      $ 7                 11,386   


          


 


          


Total goodwill

        $   14,655               $   17      $ 8               $   14,680   
    


          


 


          


The measurement periods for the valuation of assets acquired and liabilities assumed end as soon as information on the facts and circumstances that existed as of the acquisition dates becomes available, but do not exceed 12 months. Adjustments in purchase price allocations may require a recasting of the amounts allocated to goodwill retroactive to the periods in which the acquisitions occurred.

Any change in the goodwill amounts resulting from foreign currency translations and business dispositions are presented as “Other” in the table above.

As discussed in Note 16 – Segment Information, during the first quarter of fiscal year 2014, we changed our organizational structure as part of our transformation to a devices and services company. This resulted in a change in our operating segments and reporting units. We allocated goodwill to our new reporting units using a relative fair value approach. In addition, we completed an assessment of any potential goodwill impairment for all reporting units immediately prior to the reallocation and determined that no impairment existed.

 

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NOTE 9 — 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,

2013

   

June 30,

2013

 

Technology-based (a)

   $ 3,880                $ (2,288   $ 1,592      $ 3,760                $ (2,110   $ 1,650   

Marketing-related

     1,348                 (256     1,092        1,348                 (211     1,137   

Contract-based

     798                 (675     123        823                 (688     135   

Customer-related

     373                 (235     138        380                 (219     161   


          


 


 


          


 


Total

   $   6,399               $   (3,454   $   2,945      $   6,311               $   (3,228   $   3,083   
    


          


 


 


          


 


 

(a)

Technology-based intangible assets included $165 million and $218 million as of December 31, 2013 and June 30, 2013, respectively, of net carrying amount of software to be sold, leased, or otherwise marketed.

Intangible assets amortization expense was $166 million and $328 million for the three and six months ended December 31, 2013, respectively, and $198 million and $376 million for the three and six months ended December 31, 2012, respectively. Amortization of capitalized software was $50 million and $96 million for the three and six months ended December 31, 2013, respectively, and $61 million and $101 million for the three and six months ended December 31, 2012, respectively.

The following table outlines the estimated future amortization expense related to intangible assets held at December 31, 2013:

 

(In millions)       


Year Ending June 30,       

2014 (excluding the six months ended December 31, 2013)

   $ 338   

2015

     500   

2016

     410   

2017

     297   

2018

     259   

Thereafter

     1,141   


Total

   $   2,945   
    


NOTE 10 — DEBT

As of December 31, 2013, we had $23.0 billion of issued and outstanding debt, comprising $300 million of commercial paper and $22.7 billion of long-term debt, including the current portion.

Short-term Debt

As of December 31, 2013, we had $300 million of commercial paper issued and outstanding, with a weighted-average interest rate of 0.11% and maturities of 91 days. The estimated fair value of this commercial paper approximates its carrying value.

 

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In November 2013, we amended our existing credit agreement to increase our credit facility from $1.3 billion to $5.0 billion and extend the expiration date to November 14, 2018. This facility serves as a back-up for our commercial paper program. As of December 31, 2013, we were in compliance with the only financial covenant in the credit agreement, which requires us to maintain a coverage ratio of at least three times earnings before interest, taxes, depreciation, and amortization to interest expense, as defined in the credit agreement. No amounts were drawn against the credit facility during any of the periods presented.

Long-term Debt

As of December 31, 2013, the total carrying value and estimated fair value of our long-term debt, including the current portion, were $22.7 billion and $22.6 billion, respectively. This is compared to a carrying value and estimated fair value of $15.6 billion and $15.8 billion, respectively, as of June 30, 2013. These estimated fair values are based on Level 2 inputs.

The components of our long-term debt, including the current portion, and the associated interest rates were as follows as of December 31, 2013 and June 30, 2013:

 

Due Date  

Face Value

December 31,
2013

   

Face Value

June 30,
2013

   

Stated
Interest

Rate

    

Effective
Interest

Rate

 


           (In millions)               

Notes

                                         

September 27, 2013

            $ *      $ 1,000        0.875%         1.000%   

June 1, 2014

             2,000        2,000        2.950%         3.049%   

September 25, 2015

             1,750        1,750        1.625%         1.795%   

February 8, 2016

             750        750        2.500%         2.642%   

November 15, 2017

             600        600        0.875%         1.084%   

May 1, 2018

             450        450        1.000%         1.106%   

December 6, 2018 (a)

             1,250        *        1.625%         1.824%   

June 1, 2019

             1,000        1,000        4.200%         4.379%   

October 1, 2020

             1,000        1,000        3.000%         3.137%   

February 8, 2021

             500        500        4.000%         4.082%   

December 6, 2021 (b)

             2,412        *        2.125%         2.233%   

November 15, 2022

             750        750        2.125%         2.239%   

May 1, 2023

             1,000        1,000        2.375%         2.465%   

December 15, 2023 (a)

             1,500        *        3.625%         3.726%   

December 6, 2028 (b)

             2,412        *        3.125%         3.218%   

May 2, 2033  (c)

             757        715        2.625%         2.690%   

June 1, 2039

             750        750        5.200%         5.240%   

October 1, 2040

             1,000        1,000        4.500%         4.567%   

February 8, 2041

             1,000        1,000        5.300%         5.361%   

November 15, 2042

             900        900        3.500%         3.571%   

May 1, 2043

             500        500        3.750%         3.829%   

December 15, 2043 (a)

             500        *        4.875%         4.918%   


                

Total

           $   22,781      $   15,665                    
            


 


                

 

(a)

In December 2013, we issued $3.3 billion of debt securities.

 

(b)

In December 2013, we issued €3.5 billion of debt securities.

 

(c)

In April 2013, we issued €550 million of debt securities.

 

*

Not applicable.

The notes in the table above are senior unsecured obligations and rank equally with our other senior unsecured debt outstanding. Interest on these notes is paid semi-annually, except for the euro-denominated debt securities on which interest is paid annually. As of December 31, 2013 and June 30, 2013, the aggregate unamortized discount for our long-term debt, including the current portion, was $105 million and $65 million, respectively.

 

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NOTE 11 — INCOME TAXES

Our effective tax rates were approximately 17% and 18% for the three months ended December 31, 2013 and 2012, respectively, and 17% and 18% for the six months ended December 31, 2013 and 2012, respectively. Our effective tax rate was lower than the U.S. federal statutory rate primarily due to 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.

Tax contingencies and other tax liabilities were $9.2 billion and $9.4 billion as of December 31, 2013 and June 30, 2013, respectively, and were included in other long-term liabilities. While we settled a portion of the U.S. Internal Revenue Service (“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. In February 2012, the I.R.S. withdrew its 2011 Revenue Agents Report and reopened the audit phase of the examination. As of December 31, 2013, the primary unresolved issue was related to transfer pricing, which could have a significant impact on our financial statements if not resolved favorably. We believe our allowances for tax contingencies are appropriate. 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 remaining open issues will be resolved within the next 12 months. We also continue to be subject to examination by the I.R.S. for tax years 2007 to 2012.

We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2012, 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 12 — UNEARNED REVENUE

Unearned revenue by segment was as follows, with segments with significant balances shown separately:

 

(In millions)             


December 31,

2013

    June 30,
2013
 

Commercial Licensing

   $ 15,592      $ 18,460   

Commercial Other

     2,173        2,272   

Rest of the segments

     1,709        1,667   


 


Total

   $   19,474      $   22,399   
    


 


NOTE 13 — 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 between 1999 and 2005.

We obtained dismissals or reached settlements of all claims made in the United States. 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. We estimate the total remaining cost of the settlements is approximately $400 million, all of which had been accrued as of December 31, 2013.

Three similar 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. In April 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 appealed the decision to the Canadian Supreme Court. In October 2013, the Supreme Court reversed and reinstated part of the British Columbia case, which is now proceeding. The other two actions were inactive pending action by the Supreme Court on the British Columbia case.

 

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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. After the trial court dismissed or granted summary judgment on a number of Novell’s claims, trial of the one remaining claim took place from October to December 2011, and resulted in a mistrial. In July 2012, the trial court granted Microsoft’s motion for judgment as a matter of law. Novell appealed this decision to the U.S. Court of Appeals for the Tenth Circuit, which affirmed the trial court’s decision in September 2013. The Court of Appeals denied Novell’s request for rehearing and en banc review.

Patent and Intellectual Property Claims

Motorola litigation

In October 2010, Microsoft filed patent infringement complaints against Motorola Mobility (“Motorola”) with the International Trade Commission (“ITC”) and in U.S. District Court in Seattle for infringement of nine Microsoft patents by Motorola’s Android devices. Since then, Microsoft and Motorola have filed additional claims against each other in the ITC, in federal district courts in Seattle, Wisconsin, Florida, and California, and in courts in Germany and the United Kingdom. The nature of the claims asserted and status of individual matters are summarized below.

International Trade Commission

In May 2012, the ITC issued a limited exclusion order against Motorola on one Microsoft patent, which became effective on July 18, 2012. Microsoft appealed certain aspects of the ITC rulings adverse to Microsoft, and Motorola has appealed the ITC exclusion order, to the Court of Appeals for the Federal Circuit. In October 2013, the Court of Appeals ruled in Microsoft’s favor on one additional patent (since expired) and, in December 2013, affirmed the ITC’s exclusion order.

In July 2013, Microsoft filed an action in U.S. District Court in Washington, D.C. seeking an order to compel enforcement of the ITC’s May 2012 import ban against infringing Motorola products by the Bureau of Customs and Border Protection (“CBP”), after learning that CBP had failed to fully enforce the order.

In November 2010, Motorola filed an action against Microsoft in the ITC alleging infringement of five Motorola patents by Xbox consoles and accessories and seeking an exclusion order to prohibit importation of the allegedly infringing Xbox products into the U.S. At Motorola’s request, the ITC terminated its investigation as to four Motorola patents, leaving only one Motorola patent at issue. In March 2013, the administrative law judge (“ALJ”) ruled that there has been no violation of the remaining Motorola patent. Motorola sought ITC review of the ALJ’s determination, which the ITC denied in May 2013. Motorola has appealed the ITC’s decision to the U.S. Court of Appeals for the Federal Circuit.

U.S. District Court

The Seattle District Court case filed in October 2010 by Microsoft as a companion to Microsoft’s ITC case against Motorola has been stayed pending the outcome of Microsoft’s ITC case.

In November 2010, Microsoft sued Motorola for breach of contract in U.S. District Court in Seattle, alleging that Motorola breached its commitments to standards-setting organizations to license to Microsoft certain patents on reasonable and non-discriminatory (“RAND”) terms and conditions. Motorola has declared these patents essential to the implementation of the H.264 video standard and the 802.11 Wi-Fi standard. In the Motorola ITC case described above and in suits described below, Motorola or a Motorola affiliate subsequently sued Microsoft on those patents in U.S. District Courts, in the ITC, and in Germany. In February 2012, the Seattle District Court granted a partial summary judgment in favor of Microsoft ruling that (1) Motorola entered into binding contractual commitments with standards organizations committing to license its declared-essential patents on RAND terms and conditions; and (2) Microsoft is a third-party beneficiary of those commitments. After trial, the Seattle District Court set per unit royalties for Motorola’s H.264 and 802.11 patents, which resulted in an immaterial Microsoft liability. In September 2013, following trial of Microsoft’s breach of contract claim, a jury awarded $14.5 million in damages to Microsoft. Motorola has appealed.

Cases filed by Motorola in Wisconsin, California, and Florida, with the exception of one currently stayed case in Wisconsin (a companion case to Motorola’s ITC action), have been transferred to the U.S District Court in Seattle.

 

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Motorola and Microsoft both seek damages as well as injunctive relief. No trial dates have been set in any of the transferred cases, and the court has stayed these cases on agreement of the parties.

 

   

In the transferred cases, Motorola asserts 15 patents are infringed by many Microsoft products including Windows Mobile 6.5 and Windows Phone 7, Windows Marketplace, Silverlight, Windows Vista and Windows 7, Exchange Server 2003 and later, Exchange ActiveSync, Windows Live Messenger, Lync Server 2010, Outlook 2010, Office 365, SQL Server, Internet Explorer 9, Xbox, and Kinect.

 

   

In the Motorola action originally filed in California, Motorola asserts that Microsoft violated antitrust laws in connection with Microsoft’s assertion of patents against Motorola that Microsoft has agreed to license to certain qualifying entities on RAND terms and conditions.

 

   

In counterclaims in the patent actions brought by Motorola, Microsoft asserts 14 patents are infringed by Motorola Android devices and certain Motorola digital video recorders.

Germany

In July 2011, Motorola filed patent infringement actions in Germany against Microsoft and several Microsoft subsidiaries.

 

   

Two patents (one now expired) are asserted by Motorola to be essential to implementation of the H.264 video standard, and Motorola alleges that H.264 capable products including Xbox 360, Windows 7, Media Player, and Internet Explorer infringe those patents. In May 2012, the court issued an injunction relating to all H.264 capable Microsoft products in Germany. However, due to orders in the separate litigation pending in Seattle, Washington described above, Motorola is enjoined from taking steps to enforce the German injunction. Microsoft has appealed the rulings of the first instance court.

 

   

Motorola asserts that one patent covers certain syncing functionality in the ActiveSync protocol employed by Windows Phone 7, Outlook Mobile, Hotmail Mobile, Exchange Online, Exchange Server, and Hotmail Server. In April 2013, the court stayed the case pending the outcome of parallel proceedings in which Microsoft is seeking to invalidate the patent. In November 2013, the Federal Patent Court invalidated the patent in relevant part. Motorola has appealed.

 

   

Microsoft may be able to mitigate the adverse impact of any injunction issued and enforced by altering its products to avoid Motorola’s infringement claims.

 

   

Any damages would be determined in separate proceedings.

In lawsuits Microsoft filed in Germany in 2011 and 2012, Microsoft asserts Motorola Android devices infringe Microsoft patents and is seeking damages and injunctions. In 2012, regional courts in Germany issued injunctions on three of the patents Microsoft asserts. Motorola has appealed each of these cases. One judgment has been affirmed on appeal (and Motorola has further appealed), and the other two appeals are still pending. In actions filed separately by Motorola to invalidate these patents, the Federal Patent court in November and December 2013 held invalid two of the patents on which Microsoft had obtained injunctions. Microsoft has appealed. One of Microsoft’s cases seeking an injunction is still pending in the first instance court. For the cases in which Microsoft obtained injunctions, if Motorola were to prevail following all appeals, Motorola could have a claim against Microsoft for damages caused by an erroneously granted injunction.

United Kingdom

In December 2011, Microsoft filed an action against Motorola in the High Court of Justice, Chancery Division, Patents Court, in London, England, seeking to revoke the UK part of the European patent asserted by Motorola in Germany against the ActiveSync protocol. In February 2012, Motorola counterclaimed alleging infringement of the patent and seeking damages and an injunction. A trial took place in December 2012, and the court ruled that Motorola’s patent is invalid and revoked. The court also ruled that the patent, even if valid, would be licensed under the grant-back clause in Google’s ActiveSync license. Motorola appealed and the appeals court affirmed the lower court’s ruling in Microsoft’s favor in November 2013.

Other patent and intellectual property claims

In addition to these cases, there are approximately 70 other patent infringement cases pending against Microsoft.

 

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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, 2013, we had accrued aggregate liabilities of $397 million in other current liabilities and $115 million in other long-term liabilities for all of our legal matters that were contingencies as of that date. While we intend to defend these matters vigorously, adverse outcomes that we estimate could reach approximately $600 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.

Other Commitments

On September 2, 2013, we announced that we entered into a definitive agreement to acquire substantially all of Nokia’s Devices & Services business, license Nokia’s patents, and license and use Nokia’s mapping services (the “Agreement”). Under the terms of the Agreement, we agreed to pay 3.79 billion (approximately $5.0 billion) to purchase substantially all of Nokia’s Devices & Services business, and 1.65 billion (approximately $2.2 billion) to license Nokia’s patents, for a total transaction price of 5.44 billion (approximately $7.2 billion) in cash. We intend to draw upon our overseas cash resources to fund the acquisition. In connection with the Agreement, on September 23, 2013, we provided Nokia 1.5 billion ($2.0 billion) of financing in the form of convertible notes, which are included in short-term investments on our balance sheet. Nokia will repay these notes from the proceeds of the acquisition upon closing. Nokia’s shareholders approved the Agreement on November 19, 2013. We expect the acquisition will close in the first calendar quarter of 2014, subject to regulatory approvals and other closing conditions.

NOTE 14 — STOCKHOLDERS’ EQUITY

Share Repurchases

We repurchased the following shares of common stock through our share repurchase program, during the periods presented:

 

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


     2013     2012     2013     2012  

Shares of common stock repurchased

     53        58        100        91   

Value of common stock repurchased

   $   2,000      $   1,607      $   3,500      $   2,607   


Excluded from this table are shares repurchased to settle statutory employee tax withholding related to the vesting of stock awards. We repurchased all shares with cash resources. On September 16, 2013, our Board of Directors approved a $40.0 billion share repurchase program, which replaced the share repurchase program that expired September 30, 2013. The share repurchase program became effective on October 1, 2013, has no expiration date, and may be suspended or discontinued at any time without notice. As of December 31, 2013, approximately $38.0 billion remained of our $40.0 billion share repurchase program.

 

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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 2014

                                 

September 16, 2013

   $   0.28        November 21, 2013       $   2,332        December 12, 2013   

November 19, 2013

   $ 0.28        February 20, 2014       $ 2,324        March 13, 2014   


Fiscal Year 2013

                                 

September 18, 2012

   $ 0.23        November 15, 2012       $ 1,933        December 13, 2012   

November 28, 2012

   $ 0.23        February 21, 2013       $ 1,925        March 14, 2013   


The estimate of the amount to be paid as a result of the November 19, 2013 declaration was included in other current liabilities as of December 31, 2013.

 

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NOTE 15 — ACCUMULATED OTHER COMPREHENSIVE INCOME

The following table summarizes the changes in accumulated other comprehensive income by component:

 

(In millions)   

Three Months Ended

December 31,

   

Six Months Ended

December 31,

 


     2013     2012     2013     2012  

Derivatives

                                

Accumulated other comprehensive income balance, beginning of period

   $ 40      $ 47      $ 66      $ 92   

Unrealized gains (losses), net of tax effects of $2 , $7, $0 , and $(4)

     67        13        59        (10

Reclassification adjustments for gains included in revenue

     (25     (34     (44     (69

Tax expense included in provision for income taxes

     1        12        2        25   


 


 


 


Amounts reclassified from accumulated other comprehensive income

     (24     (22     (42     (44


 


 


 


Net current period other comprehensive income (loss)

     43        (9     17        (54


 


 


 


Accumulated other comprehensive income balance, end of period

   $ 83      $ 38      $ 83      $ 38   


 


 


 


Investments

                                

Accumulated other comprehensive income balance, beginning of period

   $ 2,746      $ 1,705      $ 1,794      $ 1,431   

Unrealized gains, net of tax effects of $270 , $118, $760 , and $261

     527        220        1,474        484   

Reclassification adjustments for gains included in other income (expense)

     (70     (43     (63     (28

Tax expense included in provision for income taxes

     25        15        23        10   


 


 


 


Amounts reclassified from accumulated other comprehensive income

     (45     (28     (40     (18


 


 


 


Net current period other comprehensive income

     482        192        1,434        466   


 


 


 


Accumulated other comprehensive income balance, end of period

   $ 3,228      $ 1,897      $ 3,228      $ 1,897   


 


 


 


Translation adjustments and other

                                

Accumulated other comprehensive income (loss) balance, beginning of period

   $ (55   $ 68      $ (117   $ (101

Translation adjustments and other, net of tax effects of $11 , $2, $44 , and $92

     21        3        83        172   


 


 


 


Accumulated other comprehensive income (loss) balance, end of period

   $ (34   $ 71      $ (34   $ 71   


 


 


 


Accumulated other comprehensive income, end of period

   $   3,277      $   2,006      $   3,277      $   2,006   
    


 


 


 


NOTE 16 — 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.

During the first quarter of fiscal year 2014, we changed our organizational structure as part of our transformation to a devices and services company. As a result of these changes, information that our chief operating decision maker regularly reviews for purposes of allocating resources and assessing performance changed. Therefore, beginning in fiscal year 2014, we are reporting our financial performance based on our new segments; Devices and Consumer (“D&C”) Licensing, D&C Hardware, D&C Other, Commercial Licensing, and Commercial Other. We have recast certain prior period amounts to conform to the way we internally manage and monitor segment performance during fiscal year 2014. Our reportable segments are described below.

 

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Devices and Consumer

Our D&C segments develop, market, and support products and services designed to entertain and connect people, increase personal productivity, help people simplify tasks and make more informed decisions online, and help advertisers connect with audiences. Our D&C segments are:

 

   

D&C Licensing , comprising: Windows, including all original equipment manufacturer (“OEM”) licensing (“Windows OEM”) and other non-volume licensing and academic volume licensing of the Windows operating system and related software (collectively, “Consumer Windows”); non-volume licensing of Microsoft Office, comprising the core Office product set, for consumers (“Consumer Office”); Windows Phone, including related patent licensing; and certain other patent licensing revenue;

 

   

D&C Hardware , comprising: Xbox gaming and entertainment consoles and accessories, second-party and third-party video game royalties, and Xbox LIVE subscriptions (“Xbox Platform”); Surface; and Microsoft PC accessories; and

 

   

D&C Other , comprising: Resale, including Windows Store, Xbox LIVE transactions, and Windows Phone Store; search advertising; display advertising; Subscription, comprising Office 365 Home Premium; Studios, comprising first-party video games; our retail stores; and certain other consumer products and services not included in the categories above.

Commercial

Our Commercial segments develop, market, and support software and services designed to increase individual, team, and organizational productivity and efficiency, including simplifying everyday tasks through seamless operations across the user’s hardware and software. Our Commercial segments are:

 

   

Commercial Licensing , comprising: server products, including Windows Server, Microsoft SQL Server, Visual Studio, and System Center; Windows Embedded; volume licensing of the Windows operating system, excluding academic (“Commercial Windows”); Microsoft Office for business, including Office, Exchange, SharePoint, and Lync (“Commercial Office”); Client Access Licenses, which provide access rights to certain server products (“CAL”); Microsoft Dynamics business solutions, excluding Dynamics CRM Online; and Skype; and

 

   

Commercial Other , comprising: Enterprise Services, including Premier Support Services and Microsoft Consulting Services; Cloud Services, comprising Office 365, excluding Office 365 Home Premium (“Commercial Office 365”), other Microsoft Office online offerings, Dynamics CRM Online, and Windows Azure; and certain other commercial products and online services not included in the categories above.

Revenue and cost of revenue are generally directly attributed to our segments. Certain revenue contracts are allocated among the segments based on the relative value of the underlying products and services. Cost of revenue is directly charged to the D&C Hardware segment. For the remaining segments, cost of revenue is directly charged in most cases and allocated in certain cases, generally using a relative revenue methodology.

We do not allocate operating expenses to our segments. Rather, we allocate them to our two segment groups, D&C and Commercial. Due to the integrated structure of our business, allocations of expenses are made in certain cases to incent cross-collaboration among our segment groups so that a segment group is not solely burdened by the cost of a mutually beneficial activity as we seek to deliver seamless experiences across devices, whether on premise or in the cloud.

Operating expenses are attributed to our segment groups as follows:

 

   

Sales and marketing expenses are primarily recorded directly to each segment group based on identified customer segment.

 

   

Research and development expenses are primarily shared across the segment groups based on relative gross margin but are mapped directly in certain cases where the value of the expense only accrues to that segment group.

 

   

General and administrative expenses are primarily allocated based on relative gross margin.

Certain corporate-level activity is not allocated to our segment groups, including costs of: legal, including expenses, settlements, and fines; information technology; human resources; corporate finance; and excise taxes.

 

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Item 1

 

Segment revenue and gross margin were as follows during the periods presented:

 

(In millions)   

Three Months Ended

December 31,

   

Six Months Ended

December 31,

 


     2013     2012     2013     2012  

Revenue

  

Devices and Consumer            

   Licensing    $ 5,384      $ 5,703      $ 9,727      $ 10,381   
    

Hardware

     4,729        2,808        6,214        3,892   
    

Other

     1,793        1,999        3,428        3,399   


 


 


 


    

Total Devices and Consumer

   $ 11,906