A. Overview and Basis of Presentation

Company and Background

VMware, Inc. ("VMware" or the "Company") is the leading provider of virtualization infrastructure software solutions from the desktop to the data center and to the cloud. VMware's virtualization infrastructure software solutions run on industry-standard desktop computers and servers and support a wide range of operating system and application environments, as well as networking and storage infrastructures.

Accounting Principles

The financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America.

Basis of Presentation

VMware was incorporated as a Delaware corporation in 1998 and continues to operate in large measure as a stand-alone company following the Company's acquisition by EMC Corporation ("EMC") in 2004 and following VMware's initial public offering of VMware's Class A common stock in August 2007. As of December 31, 2010, EMC holds approximately 80% of VMware's outstanding common stock, including 33.0 million shares of VMware's Class A common stock and all of VMware's Class B common stock. VMware is considered a "controlled company" under the rules of the New York Stock Exchange. VMware historically has received, and continues to receive, certain administrative services from EMC, and VMware and EMC engage in certain intercompany transactions. Costs incurred by EMC for the direct benefit of VMware, such as rent, salaries and benefits, plus a mark-up intended to approximate third-party costs, are included in VMware's consolidated financial statements. Management believes the assumptions underlying the consolidated financial statements are reasonable. However, the amounts recorded for VMware's intercompany transactions with EMC would not be considered arm's length with an unrelated third party by nature of EMC's majority ownership of VMware. Therefore, the financial statements included herein may not necessarily reflect the cash flows, results of operations and financial condition had VMware engaged in such transactions with an unrelated third party during all periods presented. Accordingly, VMware's historical financial information is not necessarily indicative of what the Company's cash flows, results of operations and financial condition will be in the future if and when VMware contracts at arm's-length with unrelated third parties for services the Company has received and currently receives from EMC.

Upon retirement of repurchased shares, VMware historically recorded the excess of the cost of treasury stock over its par value as a reduction of retained earnings. Effective 2010, the Company has reflected these amounts as a reduction of additional-paid-in-capital and reclassified historical results accordingly. The amounts reclassified were not material to VMware's consolidated financial statements and did not have an effect on VMware's total stockholders' equity.

Prior period financial statements have been reclassified to conform to current period presentation.

Principles of Consolidation

The consolidated financial statements include the accounts of VMware and its subsidiaries. All intercompany transactions and balances between VMware and its subsidiaries have been eliminated. All intercompany transactions with EMC in the consolidated statements of cash flows will be settled in cash, and changes in the intercompany balances are presented as a component of cash flows from operating activities.

 

Use of Accounting Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the reported amounts of revenues and expenses during the reporting periods, and the disclosure of contingent liabilities at the date of the financial statements. Estimates are used for, but not limited to, capitalized software development costs, trade receivable valuation, certain accrued liabilities, useful lives of fixed assets and intangible assets, valuation of acquired intangibles, revenue reserves, income taxes, stock-based compensation and contingencies. Actual results could differ from those estimates.

Revenue Recognition

VMware derives revenues from the licensing of software and related services. VMware recognizes revenues when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collectibility is probable.

The following summarizes the major terms of VMware's contractual relationships with customers and the manner in which VMware accounts for sales transactions.

License revenues

VMware recognizes revenues from the sale of software licenses when risk of loss transfers, which is generally upon electronic shipment.

VMware licenses most of its software under perpetual licenses through its channel of distributors, resellers, system vendors, systems integrators and through its direct sales force. VMware also licenses certain software products on a subscription basis. To the extent VMware offers product promotions and the promotional products are not yet available, the revenue for the entire order is deferred until such time as all product obligations have been fulfilled. Revenues relating to products that have shipped into a channel are deferred until the products are sold through the channel. VMware obtains sell-through information from distributors and certain resellers on a monthly basis. For VMware's channel partners who do not report sell-through data, VMware determines sell-through information based on payment of such distributors' and certain resellers' accounts receivable balances and other relevant factors. For software sold by system vendors that is bundled with their hardware, unless the Company has a separate license agreement with the end-user, revenue is recognized in arrears upon the receipt of binding royalty reports.

For all sales, VMware uses one of the following to constitute evidence of an arrangement:

 

•

a purchase order or equivalent;

 

•

a license agreement and a purchase order or equivalent;

 

•

a license agreement which includes language that the agreement also serves as the purchase order; or

 

•

a master agreement and a binding royalty report.

Sales through distributors and resellers are evidenced by a master distribution agreement, together with purchase orders or equivalent, on a transaction-by-transaction basis.

With limited exceptions, VMware's return policy does not allow product returns for a refund. Certain distributors and resellers may rotate stock when new versions of a product are released. VMware estimates future product returns at the time of sale based on historical return rates, levels of inventory held by distributors and resellers, and other relevant factors. Returns have not been material to date and have been in line with VMware's expectations.

VMware offers rebates to certain channel partners. When rebates are based on a set percentage of actual sales, VMware recognizes the amount of the rebates as a reduction of revenues when the underlying revenue is recognized. When rebates are earned only if a cumulative level of sales is achieved, VMware recognizes the amount of the rebates as a reduction of revenues proportionally for each sale that is required to achieve the target.

VMware also offers marketing development funds to certain channel partners. VMware records the amount of the marketing development funds, based on the maximum potential liability, as a reduction of revenues at the time the underlying revenue is recognized.

Services revenues

Services revenues consist of software maintenance and professional services. VMware recognizes software maintenance revenues ratably over the contract period, which typically ranges from one to five years. Professional services include design, implementation and training. Professional services are not considered essential to the functionality of VMware's products as these services do not alter the product capabilities and may be performed by customers or other vendors. Professional services engagements performed for a fixed fee, for which VMware is able to make reasonably dependable estimates of progress toward completion, are recognized on a proportional performance basis based on hours and direct expenses incurred. Professional services engagements that are on a time and materials basis are recognized based upon hours incurred. Revenues on all other professional services engagements are recognized upon completion.

Multiple-element arrangements

VMware software products are typically sold with software maintenance services. Vendor-specific objective evidence ("VSOE") of fair value for software maintenance services is established by the rates charged in stand-alone sales of software maintenance contracts or the stated renewal rate for software maintenance included in the license agreement. VMware software products may also be sold with professional services. VSOE of fair value for professional services is based upon the standard rates VMware charges for such services when sold separately. VMware perpetual software products may be sold with products licensed on a subscription basis. VSOE of fair value for subscription license products is established by the rates charged in stand-alone sales of subscription license products. The revenues allocated to the software license included in multiple-element contracts represent the residual amount of the contract after the fair value of the other elements has been determined. If VMware is unable to establish VSOE of fair value for one of the undelivered elements included in a multiple-element contract, the revenue is deferred until VSOE of fair value for the undelivered element has been established or the element has been delivered. If the element involves time-based delivery, the entire arrangement is recognized ratably over the delivery period.

Customers under software maintenance agreements are entitled to receive updates and upgrades on a when-and-if-available basis, and various types of technical support based on the level of support purchased. In the event specific features or functionality, entitlements, or the release number of an upgrade have been announced but not delivered, and customers will receive that upgrade as part of a current software maintenance contract, a specified upgrade is deemed created and product revenues are deferred on purchases made after the announcement date until delivery of the upgrade. The amount and elements to be deferred are dependent on whether the company has established VSOE of fair value for the upgrade. On occasion, VSOE of fair value of these upgrades is established based upon the price set by management. VMware has a history of selling such upgrades on a stand-alone basis.

Unearned revenues include unearned software maintenance fees, professional services fees and license fees.

Foreign Currency Translation

The U.S. Dollar is the functional currency of VMware's foreign subsidiaries. Gains and losses from foreign currency transactions are included in other income (expense), net and were not material on a net basis in any period presented.

Cash and Cash Equivalents and Short-Term Investments

VMware invests a portion of its excess cash primarily in money market funds, highly liquid debt instruments of the U.S. government and its agencies, U.S. municipal obligations, and U.S. and foreign corporate debt securities. VMware classifies all highly liquid investments with maturities of three months or less from date of purchase as cash equivalents and all highly liquid investments with maturities of greater than three months from date of purchase as short-term investments. VMware classifies its investments as available-for-sale. VMware may sell these securities at any time for use in current operations or for other purposes, such as consideration for acquisitions and strategic investments. Consequently, VMware may or may not hold securities with stated maturities greater than twelve months until maturity. As a result, VMware classifies its investments, which include securities with maturities beyond twelve months, as current assets in the accompanying consolidated balance sheets.

VMware carries its fixed income investments, as well as its equity investments in public companies that have readily determinable fair values, at fair value and reports unrealized gains and losses on these investments, net of estimated tax provisions or benefits, in accumulated other comprehensive income, a component of stockholders' equity. Unrealized losses which are determined to be other than temporary, as well as realized gains and losses are recorded to VMware's consolidated statements of income. Realized gains and losses on the sale of fixed income securities issued by the same issuer and of the same type are determined using the first-in first-out ("FIFO") method. Equity investments, for which VMware has the ability to exercise significant influence over the investee, are accounted for using the equity method of accounting. Under the equity method, VMware's investment is initially recorded at cost and subsequently adjusted through other income (expense), net on a go forward basis to recognize VMware's share of the investee's income (loss) after the acquisition date. If at any point VMware's share of the investee's loss exceeds VMware's investment, no further loss is recognized once VMware's investment has been reduced to zero. VMware periodically evaluates whether declines in fair values of its investments below their cost basis are other-than-temporary. This evaluation consists of several qualitative and quantitative factors, including VMware's ability and intent to hold the investment until a forecasted recovery occurs, as well as any decline in the investment quality of the security and the severity and duration of the unrealized loss.

In addition, VMware has restrictions on certain cash amounts pursuant to the terms of various agreements. VMware includes this restricted cash in other current assets in the accompanying consolidated balance sheets. The amount of restricted cash was not material in any period presented.

Allowance for Doubtful Accounts

VMware maintains an allowance for doubtful accounts for estimated probable losses on uncollectible accounts receivable. The allowance is based upon the creditworthiness of VMware's customers, historical experience, the age of the receivable and current market and economic conditions. Uncollectible amounts are charged against the allowance account. The allowance for doubtful accounts was $4.5 million and $2.5 million as of December 31, 2010 and 2009, respectively.

Property and Equipment, Net

Property and equipment, net are recorded at cost. Depreciation commences upon placing the asset in service and is recognized on a straight-line basis over the estimated useful lives of the assets, as follows:

 

Buildings		39 to 51 years
Land improvements		15 years
Furniture and fixtures		5 years
Equipment and software		2 to 5 years
Leasehold improvements		Lease term, not to exceed 5 years

Upon retirement or disposition, the asset cost and related accumulated depreciation are removed with any gain or loss recognized as operating expenses in the consolidated statements of income. Repair and maintenance costs that do not extend the economic life of the underlying assets are expensed as incurred.

Research and Development and Capitalized Software Development Costs

Costs related to research and development ("R&D") are generally charged to expense as incurred. Capitalization of material development costs of software to be sold, leased, or otherwise marketed are subject to capitalization beginning when technological feasibility has been established and ending when the product is available for general release. Judgment is required in determining when technological feasibility is established. Changes in judgment as to when technological feasibility is established, or changes in VMware's business, including go-to-market strategy, would likely materially impact the amount of costs capitalized. For example, if the length of time between technological feasibility and general availability declines in the future, the amount of costs capitalized would likely decrease with a corresponding increase in R&D expense. In addition, VMware's R&D expenses and amounts capitalized as software development costs may not be comparable to VMware's peer companies due to differences in judgment as to when technological feasibility has been reached or differences in judgment regarding when the product is available for general release. Generally accepted accounting principles require annual amortization expense of capitalized software development costs to be the greater of the amounts computed using the ratio of current gross revenue to a product's total current and anticipated revenues, or the straight-line method over the product's remaining estimated economic life. To date, VMware has amortized these costs using the straight-line method as it is the greater of the two amounts. The costs are amortized over periods ranging from 18 to 24 months, which represent the product's estimated economic life. The ongoing assessment of the recoverability of these costs requires considerable judgment by management with respect to certain external factors such as anticipated future revenue, estimated economic life, and changes in software and hardware technologies. Material differences in amortization amounts could occur as a result of changes in the periods over which VMware actually generates revenues or the amounts of revenues generated.

Unamortized software development costs were $103.3 million and $129.4 million as of December 31, 2010 and 2009, respectively, and are included in capitalized software development costs, net and other on the consolidated balance sheet. The $103.3 million of unamortized software development costs as of December 31, 2010 include $1.7 million of capitalized software development costs transferred from EMC in connection with VMware's acquisition of EMC's Ionix IT management business in the second quarter of 2010. See Note E for further information.

 

For the years ended December 31, 2010, 2009 and 2008, VMware capitalized $71.6 million (including $10.9 million of stock-based compensation), $83.5 million (including $14.9 million of stock-based compensation) and $113.6 million (including $22.7 million of stock-based compensation), respectively, of costs incurred for the development of software products. These amounts have been excluded from R&D expenses on the accompanying consolidated statements of income. Amortization expense from capitalized amounts was $99.5 million, $82.9 million and $51.6 million for the years ended December 31, 2010, 2009 and 2008, respectively. Amortization expense is included in cost of license revenues on the consolidated statements of income.

Intangible Assets and Goodwill

Intangible assets, other than goodwill, are amortized over their estimated useful lives, which range up to 13 years, during which the assets are expected to contribute directly or indirectly to future cash flows. In the years ended December 31, 2010, 2009 and 2008, VMware amortized $34.8 million, $14.1 million and $17.5 million, respectively, for intangible assets.

VMware reviews intangible assets for impairment in the fourth quarter of each year or more frequently if events or changes in business circumstances indicate that the carrying amounts of the assets may not be fully recoverable or that the useful lives of these assets are no longer appropriate.

Goodwill is initially carried at its historical cost. VMware tests goodwill for impairment in the fourth quarter of each year or more frequently if events or changes in circumstances indicate that the asset might be impaired.

To date, there have been no impairments of goodwill or other intangible assets.

Derivative Instruments

Derivative instruments and hedging activities are measured at fair value and reported as a net asset and net liability on the consolidated balance sheet, as applicable.

In order to manage VMware's exposure to foreign currency fluctuations, VMware enters into foreign currency contracts to hedge a portion of VMware's net outstanding monetary asset and liability positions. VMware's foreign currency forward contracts are generally traded on a monthly basis, with a typical contractual term of one month and are adjusted to fair value through other income (expense), net in the consolidated statements of income. The Company does not enter into speculative foreign exchange contracts for trading purposes. See Note D to the consolidated financial statements for further information.

Business Combinations

For business combinations, VMware recognizes the identifiable assets acquired, the liabilities assumed, and any non-controlling interests in an acquiree, which are measured based on the acquisition date fair value. Businesses acquired from EMC are accounted for as a business combination between entities under common control pursuant to generally accepted accounting principles. VMware includes the results of operations of the acquired businesses under common control, if material, in the period of acquisition as if it had occurred at the beginning of the period and retrospectively adjusts financial information presented for prior years. VMware recognizes the net assets under common control at their carrying values as of the date of the transfer and records the excess of the carrying values over the cash consideration as an equity transaction. Goodwill for all other business combinations is measured as the excess of consideration transferred, the fair value of any non-controlling interest, and the fair value of previously held equity interest over the net amounts of the identifiable assets acquired and the liabilities assumed at the acquisition date.

 

VMware uses significant estimates and assumptions, including fair value estimates, to determine the fair value of assets acquired and liabilities assumed and when applicable the related useful lives of the acquired assets, as of the business combination date. When those estimates are provisional, VMware refines them as necessary, during the measurement period. The measurement period is the period after the acquisition date, not to exceed one year, in which VMware may gather new information about facts and circumstances that existed as of the acquisition date to adjust the provisional amounts recognized. Measurement period adjustments are applied retrospectively. All other adjustments are recorded to the consolidated statements of income.

Costs to effect an acquisition are recorded in general and administrative expenses on the consolidated statements of income as the expenses are incurred.

Advertising

Advertising production costs are expensed as incurred. Advertising expense was $13.7 million, $5.0 million and $9.4 million in the years ended December 31, 2010, 2009 and 2008, respectively.

Income Taxes

Income taxes as presented herein are calculated on a separate tax return basis, although VMware is included in the consolidated tax return of EMC. Deferred tax assets and liabilities are recognized for the expected future tax consequences of events that have been included in the financial statements or tax returns. Deferred tax assets and liabilities are determined based on the difference between the tax basis of assets and liabilities and their reported amounts using enacted tax rates in effect for the year in which the differences are expected to reverse. Tax credits are generally recognized as reductions of income tax provisions in the year in which the credits arise. The measurement of deferred tax assets is reduced by a valuation allowance if, based upon available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.

VMware does not provide for a U.S. income tax liability on undistributed earnings of VMware's foreign subsidiaries. The earnings of non-U.S. subsidiaries, which reflect full provision for non-U.S. income taxes, are currently indefinitely reinvested in non-U.S. operations or will be remitted substantially free of additional tax.

The difference between the income taxes payable that is calculated on a separate return basis and the amount actually paid to EMC pursuant to VMware's tax sharing agreement (see Note I) is presented as a component of additional paid-in capital.

Earnings Per Share

Basic net income per share is calculated using the weighted-average number of shares of VMware's common stock outstanding during the period. Diluted earnings per share are calculated using the weighted-average number of common shares including the dilutive effect of equity awards as determined under the treasury stock method. VMware has two classes of common stock, Class A and Class B common stock. For purposes of calculating earnings per share, VMware uses the two-class method. As both classes share the same rights in dividends, basic and diluted earnings per share are the same for both classes.

Comprehensive Income

The components of comprehensive income include net income adjusted for (i) unrealized gains (losses) on available-for-sale securities, net of tax, and (ii) reclassification of (gains) losses on available-for-sale securities recognized during the period, net of taxes. See Note L to the consolidated financial statements for more information.

 

Concentrations of Risks

Financial instruments, which potentially subject VMware to concentrations of credit risk, consist principally of cash and cash equivalents, short-term investments and accounts receivable. Cash on deposit with banks exceeds the amount of insurance provided on such deposits. These deposits may be redeemed upon demand. VMware places cash, cash equivalents and short-term investments primarily in money market funds and fixed income securities and limits the amount of investment with any single issuer and any single financial institution. VMware holds a diversified portfolio of money market funds and fixed income securities, which primarily consist of various highly liquid debt instruments of the U.S. government and its agencies, U.S. municipal obligations, and U.S. and foreign corporate debt securities. VMware's fixed income investment portfolio is denominated in U.S. dollars and consists of securities with various maturities.

VMware monitors the counterparty risk to ensure adequate diversification amongst the financial institutions holding the funds. VMware also monitors counterparty risk to financial institutions with which VMware enters into derivatives to ensure that these financial institutions are of high credit quality.

VMware provides credit to distributors, resellers, and certain end-user customers in the normal course of business. Credit is generally extended to new customers based upon a credit evaluation. Credit is extended to existing customers based on ongoing credit evaluations, prior payment history and demonstrated financial stability.

As of December 31, 2010, three distributors accounted for 18%, 13% and 12%, respectively, of VMware's accounts receivable balance. As of December 31, 2009, one distributor accounted for 18% and two distributors accounted for 13% each, respectively, of VMware's accounts receivable balance.

One distributor accounted for 13% of revenues in 2010 and 16% of revenues in both 2009 and 2008, respectively, and another distributor accounted for 11%, 15% and 18% of revenues in 2010, 2009 and 2008, respectively. A third distributor accounted for 10% of revenues in 2010, but less than 10% in 2009 and 2008. One channel partner accounted for less than 10% of revenues in 2010 and 2009, but accounted for 11% of revenues in 2008, respectively.

Accounting for Stock-Based Compensation

VMware utilizes the Black-Scholes option-pricing model to determine the fair value of VMware's stock option awards. The Black-Scholes model includes assumptions regarding dividend yields, expected volatility, expected term and risk-free interest rates. These assumptions reflect the Company's best estimates, but these items involve uncertainties based on market and other conditions outside of the Company's control. VMware restricted stock unit awards are valued based on the Company's stock price on the date of grant. VMware recognizes compensation cost on a straight-line basis over the awards' vesting periods for those awards which contain only a service vesting feature.

New Accounting Pronouncements

Revenue Recognition

In September 2009, the Financial Accounting Standards Board ("FASB") issued new standards for multiple-deliverable revenue arrangements. These new standards affect the determination of when individual deliverables included in a multiple-element arrangement may be treated as separate units of accounting. In addition, these new standards modify the manner in which the transaction consideration is allocated across separately identified deliverables, eliminate the use of the residual value method of allocating arrangement consideration and require expanded disclosure. These new standards became effective for us for multiple-element arrangements entered into or materially modified on or after January 1, 2011. VMware has determined that these new standards did not have an impact on VMware's consolidated financial statements as the Company's business is currently conducted.

Software

In September 2009, the FASB issued amended standards for the accounting for certain revenue arrangements that include software elements. These new standards amend pre-existing software revenue guidance by removing from its scope tangible products that contain both software and non-software components that function together to deliver the product's functionality. These amended standards became effective for VMware for revenue arrangements entered into or materially modified on or after January 1, 2011. VMware has determined that these new standards are not applicable to the Company's business and will not have an impact on its consolidated financial statements.

Consolidations

In December 2009, the FASB issued standards for consolidation of variable interest entities ("VIEs") primarily related to the determination of the primary beneficiary of the VIE. These amended standards became effective for VMware on January 1, 2010. The adoption of these standards did not have a material impact on VMware's consolidated financial position and results of operations. These amended standards may, however, have an impact on accounting for any changes to existing relationships or future investments.

B. Earnings per Share

Basic net income per share is computed by dividing net income by the weighted-average number of common shares outstanding during the period. Diluted net income per share is computed by dividing net income by the weighted-average number of common shares outstanding and potentially dilutive securities, as calculated using the treasury stock method, outstanding during the period. Potentially dilutive securities include stock options, unvested restricted stock units, unvested restricted stock awards, other unvested restricted stock, and purchase options under VMware's employee stock purchase plan. Securities are excluded from the computations of diluted net income per share if their effect would be anti-dilutive. As of December 31, 2010, VMware had 116.4 million shares of Class A common stock and 300.0 million shares of Class B common stock outstanding that were included in the calculation of basic earnings per share. VMware uses the two-class method to calculate earnings per share as both classes share the same rights in dividends, therefore basic and diluted earnings per share are the same for both classes.

The following table sets forth the computations of basic and diluted net income per share (table in thousands, except per share data):

 

		For the Year Ended December 31,
		2010				2009				2008
Net income		$	357,439			$	197,098			$	290,133
Weighted-average shares, basic for Class A and Class B			409,805				394,269				385,068
Effect of dilutive securities			13,641				5,507				12,117
Weighted-average shares, diluted for Class A and Class B			423,446				399,776				397,185
Net income per weighted-average share, basic for Class A and Class B		$	0.87			$	0.50			$	0.75
Net income per weighted-average share, diluted for Class A and Class B		$	0.84			$	0.49			$	0.73

 

For the years ended December 31, 2010, 2009 and 2008, stock options to purchase 2.9 million, 20.6 million and 11.4 million shares, respectively, of VMware Class A common stock were excluded from the diluted earnings per share calculations because their effect would have been anti-dilutive. For the years ended December 31, 2010, 2009 and 2008, 0.1 million, 2.9 million and 5.4 million shares of restricted stock were excluded from the diluted earnings per share calculations because their effect would have been anti-dilutive.

C. Investments

During 2010, VMware began investing in fixed income securities. Investments as of December 31, 2010 consisted of the following (table in thousands):

 

		Cost or Amortized Cost				Unrealized Gains				Unrealized Losses				Aggregate Fair Value
U.S. government and agency obligations		$	379,288			$	326			$	(310	)		$	379,304
U.S. and foreign corporate debt securities			522,677				724				(286	)			523,115
Foreign governments and multi-national agency obligations			63,101				72				(13	)			63,160
Municipal obligations			660,138				111				(762	)			659,487
Asset-backed securities			17,800				9				—				17,809
Total fixed income securities			1,643,004				1,242				(1,371	)			1,642,875
Equity securities			20,000				31,800				—				51,800
Total investments		$	1,663,004			$	33,042			$	(1,371	)		$	1,694,675

Gross realized gains and gross realized losses on investments in the year ended December 31, 2010 were not material.

As of December 31, 2010, VMware did not have investments in a continuous unrealized loss position for twelve months or greater. Unrealized losses on investments as of December 31, 2010 that have been in a net loss position for less than twelve months were classified by investment category as follows (table in thousands):

 

		Fair Value				Gross Unrealized Losses
U.S. government and agency obligations		$	109,932			$	(310	)
U.S. and foreign corporate debt securities			149,831				(286	)
Foreign governments and multi-national agency obligations			26,415				(13	)
Municipal obligations			412,882				(762	)
Total investments		$	699,060			$	(1,371	)

VMware evaluated its investments in fixed income securities and publicly traded equity securities as of December 31, 2010 and determined that there were no unrealized losses that indicated an other-than-temporary impairment.

 

Contractual Maturities

The contractual maturities of investments held at December 31, 2010 consisted of the following (table in thousands):

 

		Amortized Cost Basis				Aggregate Fair Value
Due within one year		$	753,201			$	753,370
Due after 1 year through 5 years			776,933				776,635
Due after 5 years			112,870				112,870
Total		$	1,643,004			$	1,642,875

D. Fair Value Measurements and Derivative Instruments

Fair Value Measurements

Generally accepted accounting principles provide that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that is determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, generally accepted accounting principles established a three-tier value hierarchy, which prioritizes the inputs used in measuring fair value as follows: (Level 1) inputs are quoted prices in active markets for identical assets or liabilities; (Level 2) inputs other than the quoted prices included within Level 1 that are observable for the assets or liabilities, either directly or indirectly; and (Level 3) unobservable inputs for the assets or liabilities in which there is little or no market data, which requires VMware to develop its own assumptions.

VMware's Level 1 classification of the fair value hierarchy includes money market funds, available-for-sale equity securities and certain available-for-sale fixed income securities because these securities are valued using quoted prices in active markets for identical assets. VMware's Level 2 classification includes the remainder of the available-for-sale fixed income securities because these securities are priced using quoted market prices for similar instruments and non-binding market prices that are corroborated by observable market data.

The following table sets forth the fair value hierarchy of VMware's money market funds and available-for-sale securities, including those securities classified within cash and cash equivalents on the consolidated balance sheet, that were required to be measured at fair value as of December 31, 2010 (table in thousands):

 

		Level 1				Level 2				Total
Money-market funds		$	1,436,319			$	—			$	1,436,319
U.S. government and agency obligations			66,762				312,543				379,305
U.S. and foreign corporate debt securities			—				537,544				537,544
Foreign governments and multi-national agency obligations			—				63,161				63,161
Municipal obligations			—				659,487				659,487
Asset-backed securities			—				55,749				55,749
Equity securities			51,800				—				51,800
Total cash equivalents and investments		$	1,554,881			$	1,628,484			$	3,183,365

 

VMware's valuation inputs for foreign currency forward contracts are based on quoted prices and quoted pricing intervals from public data sources. These contracts are typically classified within Level 2 of the fair value hierarchy and are discussed below in the derivative instruments section. VMware does not have any assets or liabilities that fall into Level 3 of the fair value hierarchy.

Derivative Instruments

In May 2009, VMware started to invoice and collect in the Euro, the British Pound, the Japanese Yen and the Australian Dollar in their respective regions. Since July 2009, in order to manage its exposure to foreign currency fluctuations, VMware has entered into foreign currency forward contracts to hedge a portion of its net outstanding monetary assets and liabilities against movements in certain foreign exchange rates. These forward contracts are not designated as hedging instruments under applicable accounting guidance, and therefore all changes in the fair value of the forward contracts are reported in other income (expense), net in the consolidated statements of income. The gains and losses on VMware's foreign currency forward contracts generally offset the majority of the gains and losses associated with the underlying foreign-currency denominated assets and liabilities that VMware hedges. VMware does not enter into speculative foreign exchange contracts for trading purposes.

VMware's foreign currency forward contracts are generally traded on a monthly basis with a typical contractual term of one month. As of December 31, 2010, VMware had outstanding forward contracts with a total notional value of $238.9 million. The fair value of these forward contracts was immaterial as of December 31, 2010 and therefore excluded from the table above. The fair value was measured under Level 2 sources as discussed above.

E. Business Combinations, Goodwill and Intangible Assets, Net

Business Combinations

The results of operations of all acquired companies and transferred net assets mentioned below have been included in VMware's consolidated financial statements from the respective dates of purchase or transfer, as applicable. Pro forma results of operations have not been presented as the results of the acquired companies and transferred net assets, prior to being acquired by VMware, were not material, individually or in aggregate, to the consolidated results of operations in the years ended December 31, 2010, 2009 or 2008.

 

Fiscal Year 2010

Business Acquisitions

In the year ended December 31, 2010, VMware acquired six companies, which were not material to VMware's consolidated financial statements, either individually or in the aggregate. The aggregate consideration for these acquisitions was $293.0 million, net of cash acquired. The following table summarizes the allocation of the consideration paid to the fair value of the tangible and intangible assets acquired and liabilities assumed (table in thousands):

 

Other current assets		$	6,328
Intangible assets			114,100
Goodwill			178,160
Deferred tax assets			48,323
Total tangible and intangible assets acquired			346,911
Unearned revenue			(21,425	)
Deferred tax liabilities			(30,103	)
Accrued liabilities and other			(2,413	)
Total liabilities assumed			(53,941	)
Fair value of tangible and intangible assets acquired and liabilities assumed		$	292,970

Transfer of Net Assets Under Common Control

In April 2010, VMware acquired certain software product technology and expertise from EMC's Ionix information technology ("IT") management business for cash consideration of $175.0 million. The acquired software product technology and expertise complement VMware's existing development efforts and expand its vCenter product family. EMC retained the Ionix brand and continues to offer customers the products acquired by VMware, pursuant to the ongoing reseller agreement between EMC and VMware. Additionally, contingent amounts totaling up to $25.0 million may be payable to EMC by the end of the second anniversary of the transfer. These amounts are contingent on EMC achieving certain revenue milestones.

The net assets and expertise acquired from EMC constituted a business and were accounted for as a business combination between entities under common control pursuant to generally accepted accounting principles. Accordingly, VMware included the carrying values of the transferred assets and liabilities as of the date of transfer in its consolidated financial statements, as well as recorded the excess of the carrying values over the cash consideration as an equity transaction. Contingent consideration, if any, paid by VMware to EMC will be recorded as an equity transaction when due. VMware did not revise its historical consolidated financial statements as the historical impact of the acquired net assets was not material.

During the three months ended December 31, 2010, $10.6 million of the $25.0 million contingent amounts was paid to EMC. This amount was recorded as an offset to the initial capital contribution from EMC.

 

The following table summarizes the net carrying values of the tangible and intangible assets and liabilities transferred to VMware and the capital contribution from EMC, as of the transfer date, and exclude the subsequent contingent consideration paid referenced above (table in thousands):

 

Property and equipment		$	3,092
Other assets			1,383
Deferred tax asset			48,618
Intangible assets			37,029
Goodwill			275,260
Total tangible and intangible assets acquired			365,382
Unearned revenue			(17,990	)
Deferred tax liabilities			(2,888	)
Other liabilities			(1,638	)
Capital contribution from EMC			(167,866	)
Total liabilities assumed and capital received			(190,382	)
Tangible and intangible assets acquired and liabilities assumed, and capital received		$	175,000

Fiscal Year 2009

On September 15, 2009, VMware acquired all of the remaining outstanding capital stock of SpringSource Global, Inc. ("SpringSource"), under the terms of an Agreement and Plan of Merger entered into in August 2009. The SpringSource acquisition was accounted for as a business combination.

The aggregate consideration transferred to acquire SpringSource was $389.2 million, which included cash of $373.0 million and the fair value of stock options assumed attributed to pre-combination services of $16.2 million. In addition, the Company assumed stock options attributed to post-combination services and issued restricted common stock with a total fair value of $44.6 million.

In accordance with the merger agreement, the number of VMware stock options into which assumed SpringSource stock options were converted and the number of shares of restricted common stock that were issued were determined based on a ratio. The ratio was derived from the per share merger consideration payable to holders of SpringSource capital stock and the ten-day trading average of VMware's Class A common stock two trading days immediately prior to September 15, 2009. The assumed vested and unvested stock options converted into 652,253 and 476,081, respectively, of VMware stock options to purchase Class A common stock with a weighted-average exercise price of $4.87 per share. In addition, 572,492 shares of VMware Class A restricted common stock were issued to certain employees of SpringSource who agreed to accept shares of VMware Class A common stock subject to vesting restrictions in lieu of a portion of their cash merger proceeds. The shares are subject to vesting restrictions based upon continued employment with VMware. Subject to meeting the vesting requirements, the holders of the shares will receive a guaranteed minimum value that is equivalent to the portion of their cash merger proceeds foregone to receive the shares. To the extent that the fair value of the shares is less than the guaranteed minimum value, the difference will be paid in cash upon vesting. At December 31, 2010, the fair value of shares exceeded the minimum value guarantee.

The Company included the fair value of the stock options assumed by VMware attributed to pre-combination services of $16.2 million in the consideration transferred for the acquisition. The fair value of the stock options attributed to post-combination services and the fair value of the restricted common stock of $44.6 million were not included in the consideration transferred and are being recognized as stock-based compensation expense over their remaining requisite service periods. The fair value of the stock options was estimated using a Black-Scholes option-pricing model with the following weighted-average assumptions: i) market price of $40.00 per share, which was the closing price of VMware's Class A common stock on the acquisition date; ii) expected term of 1.6 years; iii) risk-free interest rate of 0.7%; iv) annualized volatility of 38.1%; and v) no dividend yield. The weighted-average acquisition-date fair value of the assumed stock options attributed to post-combination services was $35.02. The fair value of the restricted common stock was based on the acquisition-date closing price of $40.00 per share for VMware's Class A common stock.

In connection with the acquisition, VMware also agreed to offer additional equity incentives to SpringSource employees. Accordingly, VMware granted an aggregate of approximately 2.3 million stock options and 0.8 million restricted stock units under its 2007 Equity and Incentive Plan shortly after the close of the acquisition. Stock-based compensation expense of approximately $58 million will be recognized over the four-year vesting term of the awards. Of the total $58 million in stock-based compensation expense, approximately $14 million and $4 million were recorded during the years ended December 31, 2010 and 2009, respectively, on VMware's consolidated statement of income.

The following table summarizes the allocation of the consideration paid to the fair value of the tangible and intangible assets acquired and liabilities assumed as of December 31, 2009, and reflect immaterial adjustments made in 2010 to finalize the purchase price allocation (table in thousands):

 

Cash		$	16,703
Other current assets			8,147
Property and equipment			1,071
Intangible assets			46,000
Goodwill			340,092
Deferred tax asset and other assets			16,405
Total assets acquired			428,418
Deferred tax liability			(16,761	)
Unearned revenue			(7,811	)
Other current liabilities			(3,063	)
Income taxes payable			(9,925	)
Total liabilities assumed			(37,560	)
Fair value of identifiable assets acquired and liabilities assumed		$	390,858

As required by generally accepted accounting principles, VMware remeasured a previously held equity interest in SpringSource to a fair value of $10.9 million immediately before the acquisition date and recorded a gain of $5.9 million in other income (expense), net on the consolidated statements of income for the year ended December 31, 2009. The $10.9 million was recorded to goodwill, bringing the total amount of goodwill related to SpringSource to $350.0 million for the year ended December 31, 2009. The $10.9 million in goodwill is not included in the table above as it is not considered part of the purchase price. The $350.0 million in goodwill represents the excess of the consideration transferred and the fair value of the previously held equity interest over the fair values assigned to the assets acquired and liabilities assumed, and was allocated to VMware's one reporting unit. Management believes that the goodwill mainly represents the synergies expected from combining the technologies of VMware and SpringSource. None of the goodwill was deductible for income tax purposes.

 

Fiscal Year 2008

On July 1, 2008, VMware acquired all of the outstanding capital stock of a privately-held application performance management software company. The aggregate consideration transferred in this acquisition was $60.8 million, which includes cash of $58.4 million and the fair value of stock options assumed attributed to pre-combination services of $2.4 million.

The following table summarizes the allocation of the consideration paid to the fair value of the tangible and intangible assets acquired and liabilities assumed as of December 31, 2008, and reflect immaterial adjustments made in 2009 to finalize the purchase price allocation (table in thousands):

 

Cash		$	216
Intangible assets			18,503
Goodwill			52,803
Assets acquired			5,511
Total assets acquired			77,033
Total liabilities assumed			(16,209	)
Fair value of identifiable assets acquired and liabilities assumed		$	60,824

In addition to the above acquisition, VMware acquired six companies during 2008 for aggregate cash consideration of $80.3 million, net of cash acquired and including transaction costs. In connection with these acquisitions, the Company acquired technologies that are complementary to VMware's core virtualization technology. Acquired intangibles totaled $23.9 million, consisted primarily of purchased technology, and have a weighted-average estimated useful life of 7.1 years. The excess of the purchase price over the fair value of the net assets acquired was $67.2 million and is classified as goodwill on the consolidated balance sheet, which reflects adjustments made in 2009 to finalize the purchase price allocations.

The purchase prices for the companies acquired in 2008 were allocated to the assets acquired and the liabilities assumed based on their final fair value.

Goodwill

Goodwill is tested for impairment on an annual basis and between annual tests if the Company becomes aware of any events occurring or changes in circumstances that would indicate a reduction in the fair value of the goodwill below its carrying amount. Changes in the carrying amount of goodwill for the years ended December 31, 2010 and 2009 consisted of the following (table in thousands):

 

		December 31,
		2010				2009
Balance, beginning of the year		$	1,115,769			$	771,088
Increase in goodwill related to business combinations			453,420				350,036
Deferred tax adjustments to purchase price allocations on previous acquisitions			2,062				(3,752	)
Other adjustments to purchase price allocations on previous acquisitions			(2,651	)			(1,603	)
Balance, end of the year		$	1,568,600			$	1,115,769

 

Intangible Assets, Net

Intangible assets, net, excluding goodwill, as of December 31, 2010 and 2009, consisted of the following (table in thousands):

 

2010		Weighted-Average Useful Lives (in years)				Gross Carrying Amount				Accumulated Amortization				Net Book Value
Purchased technology			4.8			$	279,052			$	(157,409	)		$	121,643
Customer relationships and customer lists			7.9				88,994				(23,856	)			65,138
Trademarks and tradenames			6.2				24,780				(11,116	)			13,664
Other			4.3				18,425				(7,942	)			10,483
Total intangible assets, net, excluding goodwill						$	411,251			$	(200,323	)		$	210,928

 

2009		Weighted-Average Useful Lives (in years)				Gross Carrying Amount				Accumulated Amortization				Net Book Value
Purchased technology			4.9			$	168,822			$	(114,804	)		$	54,018
Customer relationships and customer lists			8.6				37,694				(6,451	)			31,243
Trademarks and tradenames			7.4				14,680				(7,607	)			7,073
Other			4.3				8,625				(6,402	)			2,223
Total intangible assets, net, excluding goodwill						$	229,821			$	(135,264	)		$	94,557

Amortization expense on intangibles was $34.8 million, $14.1 million and $17.5 million in the years ended December 31, 2010, 2009 and 2008, respectively. Based on intangible assets recorded as of December 31, 2010 and assuming no subsequent additions or impairment of underlying assets, the remaining estimated annual amortization expense is expected to be as follows (table in thousands):

 

2011		$	51,393
2012			49,921
2013			35,605
2014			28,101
2015			18,539
Thereafter			27,369
Total		$	210,928

F. Property and Equipment, Net

Property and equipment, net, as of December 31, 2010 and 2009 consisted of the following (table in thousands):

 

		December 31,
		2010				2009
Equipment and software		$	438,384			$	327,148
Buildings and improvements			270,786				256,758
Furniture and fixtures			52,613				48,075
Construction in progress			3,082				5,892
Total property and equipment			764,865				637,873
Accumulated depreciation			(345,800	)			(235,517	)
Total property and equipment, net		$	419,065			$	402,356

Depreciation expense was $114.2 million, $102.3 million and $89.5 million in the years ended December 31, 2010, 2009 and 2008, respectively.

In conjunction with the completion of portions of its Washington data center facility, VMware increased the estimated useful lives of certain fixed assets from 3 to 5 years during the second quarter of 2009. This change in estimate was prospectively applied beginning on April 1, 2009. In the year ended December 31, 2009, this change in estimate reduced depreciation expense by $10.7 million. After considering the tax effect on the reduction in depreciation expense, there was a $0.02 impact on basic and diluted earnings per share in the year ended December 31, 2009. In the second quarter of 2008, VMware increased the estimated useful lives of computers and other related equipment from 2 years to 3 years to match the length of the related warranty contracts. In the year ended December 31, 2008, these changes in estimates reduced depreciation expense by $10.4 million and increased both basic and diluted earnings per share by $0.02, from what would have been reported otherwise in the year ended December 31, 2008. VMware reviewed and revised the useful lives of these fixed assets in 2009 and 2008 after considering (i) the estimated future benefits the Company expects to receive from those assets, (ii) the pattern of consumption of those benefits and (iii) the information available regarding those benefits.

G. Accrued Expenses and Other

Accrued expenses as of December 31, 2010 and 2009 consisted of the following (table in thousands):

 

		December 31,
		2010				2009
Salaries, commissions, bonuses and benefits		$	242,180			$	174,207
Accrued partner liabilities			94,676				77,264
Other			122,957				83,052
Total accrued expenses		$	459,813			$	334,523

Accrued partner liabilities relate to rebates and marketing development fund accruals for channel partners, system vendors and systems integrators, as well as accrued royalties.

H. Note Payable to EMC

In April 2007, VMware declared an $800.0 million dividend to EMC paid in the form of a note payable, of which $450.0 million remained outstanding as of December 31, 2010. The note matures in April 2012, with interest payable quarterly in arrears commencing June 30, 2007. The interest rate resets quarterly and bears an interest rate of the 90-day LIBOR plus 55 basis points. In the years ended December 31, 2010, 2009 and 2008, $4.1 million, $6.5 million and $18.6 million, respectively, of interest expense was recorded related to the note payable. The note may be repaid, without penalty, at any time commencing July 2007. No repayments of principal were made during 2010 and 2009.

I. Income Taxes

The domestic and foreign components of income before provisions for income taxes were as follows (table in thousands):

 

		For the Year Ended December 31,
		2010				2009				2008
Domestic		$	127,293			$	31,690			$	63,588
International			289,082				191,759				255,697
Total		$	416,375			$	223,449			$	319,285

VMware's provision for income taxes consisted of the following (table in thousands):

 

		For the Year Ended December 31,
		2010				2009				2008
Federal:
Current		$	65,796			$	41,114			$	(27,524	)
Deferred			(42,158	)			(35,908	)			38,348
			23,638				5,206				10,824
State:
Current			15,496				6,070				(824	)
Deferred			(9,055	)			(3,630	)			4,044
			6,441				2,440				3,220
Foreign:
Current			34,592				19,643				18,592
Deferred			(5,735	)			(938	)			(3,484	)
			28,857				18,705				15,108
Total provision for income taxes		$	58,936			$	26,351			$	29,152

A reconciliation of VMware's income tax rate to the statutory federal tax rate is as follows:

 

		For the Year Ended December 31,
		2010				2009				2008
Statutory federal tax rate			35.0	%			35.0	%			35.0	%
State taxes, net of federal benefit			1.5	%			1.1	%			1.0	%
Tax rate differential for international jurisdictions			(17.3	%)			(21.5	%)			(23.3	%)
U.S. tax credits			(8.6	%)			(8.5	%)			(6.7	%)
Permanent items and other			3.6	%			5.7	%			3.1	%
Effective tax rate			14.2	%			11.8	%			9.1	%

 

The components of the current and non-current deferred tax assets and liabilities were as follows (table in thousands):

 

		December 31,
		2010								2009
		Deferred Tax Asset				Deferred Tax Liability				Deferred Tax Asset				Deferred Tax Liability
Current:
Accruals and allowances		$	30,673			$	—			$	20,990			$	—
Unearned revenue			82,557				—				52,507				—
Net operating loss carryforwards			292				—				—				—
Valuation allowance			(12,833	)			—				(10,137	)			—
Total current			100,689				—				63,360				—
Non-current:
Property, plant and equipment, net			—				(20,227	)			—				(19,665	)
Intangible and other, net			—				(1,551	)			—				(40,635	)
Stock-based compensation			52,095				—				49,135				—
Unearned revenue			24,755				—				19,785				—
Other non-current liabilities			—				(8,318	)			—				—
Tax credit and net operating loss carryforwards			95,316				—				52,324				—
Valuation allowance			(23,040	)			—				(18,715	)			—
Total non-current			149,126				(30,096	)			102,529				(60,300	)
Total deferred tax assets and liabilities		$	249,815			$	(30,096	)		$	165,889			$	(60,300	)

VMware has U.S. federal net operating loss carryforwards of $117.9 million from acquisitions made since 2006. These carryforwards expire at different periods through 2030. Portions of these carryforwards are subject to annual limitations. VMware expects to be able to fully use these net operating losses against future income. Also resulting from acquisitions since 2006, VMware has state net operating loss carryforwards of $200.7 million expiring at different periods through 2030. A valuation allowance was recorded to reduce gross deferred tax assets to an amount VMware believes is more likely than not to be realized. The valuation allowance is attributable to the uncertainty regarding the realization of state tax credit carryforward benefits. VMware has non-U.S. net operating losses of $12.1 million resulting from a non-U.S. acquisition in 2009. These net operating losses have an unlimited carryforward period. VMware expects to be able to fully use these net operating losses against future non-U.S. income. Also resulting from an acquisition in 2009, VMware has non-U.S. net operating losses of $15.5 million that are subject to a full valuation allowance as VMware believes it is more likely than not that no tax benefit will be realized from these losses.

U.S. income taxes have not been provided on certain undistributed earnings of non-U.S. subsidiaries of approximately $900.3 million and $620.6 million at December 31, 2010 and 2009, respectively, because such earnings are considered to be reinvested indefinitely outside of the U.S., and it is not practicable to estimate the amount of tax that may be payable upon repatriation.

As of December 31, 2010, VMware had a net income tax receivable of $144.3 million, which was comprised of amounts due from EMC for VMware's stand-alone federal taxable loss for the fiscal year ending December 31, 2010 and for a refund of an overpayment related to the consolidated federal and state income taxes for the fiscal year ended December 31, 2009. The receivable for 2010 arose because VMware had a stand-alone taxable loss for the year ended December 31, 2010, which was primarily attributable to tax deductions arising from both non-qualified stock option exercises and from restricted stock when the restrictions lapsed. Under the tax sharing agreement with EMC, EMC is obligated to pay to VMware an amount equal to the tax benefit generated by VMware that EMC will recognize on its consolidated tax return. At December 31, 2009, VMware had an income tax receivable due from EMC for $3.0 million as a result of comparing the state tax provision for fiscal year ended December 31, 2008 to the final tax return. During the year ended December 31, 2009, EMC paid VMware $107.6 million due to VMware's stand-alone taxable loss for the year ended December 31, 2008, which was primarily attributable to tax deductions arising from both non-qualified stock option exercises and from restricted stock when the restrictions lapsed. Under the tax sharing agreement with EMC, EMC is obligated to pay VMware an amount equal to the tax benefit generated by VMware that EMC will recognize on its consolidated tax return.

The difference between the income taxes payable that is calculated on a separate return basis and the amount actually paid to EMC pursuant to VMware's tax sharing agreement is presented as a component of additional paid-in capital. These differences resulted in an increase in additional paid-in capital of $6.5 million in the year ended December 31, 2010 and a decrease in additional paid-in capital of $8.0 million in the year ended December 31, 2009.

As of December 31, 2010, VMware had gross unrecognized tax benefits totaling $103.9 million, which excludes $5.4 million of offsetting tax benefits. As of December 31, 2009, VMware had gross unrecognized tax benefits totaling $80.8 million, which excludes $4.2 million of offsetting tax benefits. Approximately $104.4 million of VMware's unrecognized tax benefits, if recognized, would reduce income tax expense and lower VMware's effective tax rate in the period or periods recognized. The net unrecognized tax benefits of $104.4 million as of December 31, 2010 would, if recognized, benefit VMware's effective income tax rate. The $104.4 million of net unrecognized tax benefits were classified as a non-current liability on the consolidated balance sheet. It is reasonably possible within the next 12 months that audit resolutions could potentially reduce total unrecognized tax benefits by between approximately $20 million and $24 million. Audit outcomes and the timing of audit settlements are subject to significant uncertainty.

VMware recognizes interest expense and penalties related to income tax matters in the income tax provision. VMware had accrued $3.9 million of interest as of January 1, 2010 and $4.1 million of interest as of December 31, 2010 associated with unrecognized tax benefits. These amounts are included as components of the $104.4 million net unrecognized tax benefits at December 31, 2010 and $78.0 million net unrecognized tax benefits at December 31, 2009. Income tax expense for the year ended December 31, 2010 included interest of $0.3 million associated with uncertain tax positions.

A reconciliation of the beginning and ending amount of gross unrecognized tax benefits, excluding interest associated with unrecognized tax benefits, is as follows (table in thousands):

 

		For the Year Ended December 31,
		2010				2009				2008
Balance, beginning of the year		$	84,970			$	48,407			$	19,198
Tax positions related to current year:
Additions			28,177				38,153				30,089
Tax positions related to prior years:
Additions			6,850				—				503
Reductions			(10,378	)			(3,169	)			—
Foreign currency effects			(325	)			1,579				(1,383	)
Balance, end of the year		$	109,294			$	84,970			$	48,407

 

There were no material settlements during 2010. Due to the increased complexity in international operations, including judgments in determining the appropriate tax jurisdictions for revenue and expense items, the Company's unrecognized tax benefits will likely increase in 2011. The Company cannot reasonably estimate the increase.

VMware is subject to U.S. federal income tax and various state, local and international income taxes in numerous jurisdictions. VMware's domestic and international tax liabilities are subject to the allocation of revenues and expenses in different jurisdictions and the timing of recognizing revenues and expenses. Additionally, the amount of income taxes paid is subject to the VMware's interpretation of applicable tax laws in the jurisdictions in which it files.

The U.S. federal income tax audit for 2007 and 2008 commenced during 2009 and is expected to conclude in 2011. VMware has income tax audits in progress in numerous state, local and international jurisdictions in which it operates. In the VMware international jurisdictions that comprise a significant portion of its operations, the years that may be examined vary, with the earliest year being 2004. Based on the outcome of examinations of VMware, the result of the expiration of statutes of limitations for specific jurisdictions or the result of ruling requests from taxing authorities, it is reasonably possible that the related unrecognized tax benefits could change from those recorded in the statement of financial position. It is possible that one or more of these audits may be finalized within the next twelve months. However, based on the status of examinations, and the protocol of finalizing audits, it is not possible to estimate the impact of such changes, if any, to the previously recorded uncertain tax positions.