SUBSCRIBE TO TMCnet
TMCnet - World's Largest Communications and Technology Community
 
| More

TMCNet:  MICROSOFT CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

[January 24, 2013]

MICROSOFT CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

(Edgar Glimpses Via Acquire Media NewsEdge) RESULTS OF OPERATIONS Note About Forward-Looking Statements Certain statements in this report, other than purely historical information, including estimates, projections, statements relating to our business plans, objectives, and expected operating results, and the assumptions upon which those statements are based, are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.



Forward-looking statements may appear throughout this report, including without limitation, the following sections: "Management's Discussion and Analysis," and "Risk Factors." These forward-looking statements generally are identified by the words "believe," "project," "expect," "anticipate," "estimate," "intend," "strategy," "future," "opportunity," "plan," "may," "should," "will," "would," "will be," "will continue," "will likely result," and similar expressions.

Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially from the forward-looking statements. A detailed discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section titled "Risk Factors" (Part II, Item 1A of this Form 10-Q). We undertake no obligation to update or revise publicly any forward-looking statements, whether because of new information, future events, or otherwise.

OVERVIEW The following management's discussion and analysis ("MD&A") is intended to help the reader understand the results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our Annual Report on Form 10-K for the year ended June 30, 2012 and our financial statements and accompanying Notes to Financial Statements in this Form 10-Q.

Microsoft is a technology leader focused on helping people and businesses throughout the world realize their full potential. We create technology that transforms the way people work, play, and communicate across a wide range of computing devices.

We generate revenue by developing, licensing, and supporting a wide range of software products, by offering an array of services, including cloud-based services to consumers and businesses, by designing and selling hardware that integrates with our cloud-based services, and by delivering relevant online advertising to a global audience. Our most significant expenses are related to compensating employees, designing, manufacturing, marketing, and selling our products and services, and income taxes.

Industry Trends Our industry is dynamic and highly competitive, with frequent changes in both technologies and business models. Each industry shift is an opportunity to conceive new products, new technologies, or new ideas that can further transform the industry and our business. At Microsoft, we push the boundaries of what is possible through a broad range of research and development activities that seek to anticipate the changing demands of customers, industry trends, and competitive forces.

Key Opportunities and Investments We invest research and development resources in new products and services in the areas where we see significant opportunities to drive future growth. As we look forward, the capabilities and accessibility of PCs, tablets, phones, televisions, and other devices powered by rich software platforms and applications continue to grow. With this trend, we believe the full potential of software will be seen and felt in how people use these devices and the associated services at work and in their personal lives.

Devices with End-User Services We work with an ecosystem of partners to deliver a broad spectrum of Windows devices. In some cases, we build our own devices, as we have chosen to do with Xbox and Surface. In all our work with partners and on our own devices, we focus on delivering seamless services and experiences across devices. As consumer services and hardware advance, we expect they will continue to better complement one another, connecting the devices people use daily to unique communications, productivity, and entertainment services from Microsoft and our partners and developers around the world.

31 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Windows 8 reflects this shift. Launched in October 2012 on a variety of state-of-the-art hardware, Windows 8 is built to take advantage of our consumer cloud services. Windows 8 is made for both personal and professional use and unites the light, thin, and convenient aspects of a tablet with the power of a PC. For example, Xbox Music, Video, Games, and SmartGlass applications make it possible to select and experience entertainment across a range of devices by simplifying and increasing the accessibility of those experiences. SkyDrive, our cloud storage solution, connects content across all of a user's devices. Bing's search technologies in Windows 8 are designed to help users get more done. Skype has a new Windows 8 application and connects directly to the new Office.

The new Office is designed for Windows 8 and takes advantage of new mobile form factors with touch and pen capabilities. It unlocks new experiences for reading, note taking, meetings, and communications and brings social experiences directly into productivity and collaboration scenarios. The combination of a Windows 8 tablet with OneNote and SkyDrive will transform how to take notes, annotate documents, and share information.

Services for the Enterprise Today, businesses face important opportunities and challenges. Enterprise IT departments are asked to deploy technology that drives business strategy forward. They decide what solutions will make employees more productive, collaborative, and satisfied. They work to unlock business insights from a world of data. At the same time, they must manage and secure corporate information that employees access across a growing number of personal and corporate devices.

To address these opportunities, businesses look to our world-class business applications like Microsoft Dynamics, Office, Exchange, SharePoint, Lync, and our business intelligence solutions. They rely on our technology to manage employee corporate identity and to protect their corporate data. And, increasingly, businesses of all sizes are looking to Microsoft to realize the benefits of the cloud.

Helping businesses move to the cloud is one of our largest opportunities.

Cloud-based solutions provide customers with software, services, and content over the Internet by way of shared computing resources located in centralized data centers. The shift to the cloud is driven by three important economies of scale: larger data centers can deploy computational resources at significantly lower cost per unit than smaller ones; larger data centers can coordinate and aggregate diverse customer, geographic, and application demand patterns improving the utilization of computing, storage, and network resources; and multi-tenancy lowers application maintenance labor costs for large public clouds. Because of the improved economics, the cloud offers unique levels of elasticity and agility that enable new solutions and applications. For businesses of all sizes, the cloud creates the opportunity to focus on innovation while leaving non-differentiating activities to reliable and cost-effective providers.

Unique to Microsoft, we continue to design and deliver cloud solutions that allow our customers to use both the cloud and their on-premise assets however best suits their own needs. For example, a company can choose to deploy Office or Microsoft Dynamics on premises, as a cloud service, or a combination of both.

With Windows Server 2012, Windows Azure, and System Center infrastructure, businesses can deploy applications in their own datacenter, a partner's datacenter, or in Microsoft's datacenter with common security, management, and administration across all environments, with the flexibility and scale they desire. Our business customers tell us these hybrid capabilities are critical to harnessing the power of the cloud so they can reach new levels of efficiency and tap new areas of growth.

Our Future Opportunity There are several distinct areas of technology that we are focused on driving forward. Our goal is to lead the industry in these areas over the long term, which we expect will translate to sustained growth well into the future. We are investing significant resources in: • Developing new form factors that have increasingly natural ways to use them, including touch, gestures, and speech.

• Making technology more intuitive and able to act on our behalf, instead of at our command, with machine learning.

• Building and running cloud services in ways that unleash new experiences and opportunities for businesses and individuals.

32 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 • Firmly establishing our Windows platform across the PC, tablet, phone, server, and cloud to drive a thriving ecosystem of developers, unify the cross-device user experience, and increase agility when bringing new advances to market.

• Delivering new scenarios with improvements in how people learn, work, play, and interact with one another.

We believe the breadth of our devices and services portfolio, our large, global partner and customer base, and the growing Windows ecosystem position us to be a leader in these areas.

Economic Conditions, Challenges and Risks As discussed above, our industry is dynamic and highly competitive. We must anticipate changes in technology and business models. Our model for growth is based on our ability to initiate and embrace disruptive technology trends, to enter new markets, both in terms of geographies and product areas, and to drive broad adoption of the products and services we develop and market.

At Microsoft, we prioritize our investments among the highest long-term growth opportunities. These investments require significant resources and are multi-year in nature. The products and services we bring to market may be developed internally, brought to market as part of a partnership or alliance, or through acquisition.

Our success is highly dependent on our ability to attract and retain qualified employees. We hire a mix of university and industry talent worldwide. Microsoft competes for talented individuals worldwide by offering broad customer reach, scale in resources, and competitive compensation.

Demand for our software, services, and hardware has a strong correlation to global macroeconomic factors. The current macroeconomic factors remain dynamic.

See a discussion of these factors and other risks under Risk Factors (Part II, Item 1A. of this Form 10-Q).

Seasonality Our revenue historically has fluctuated quarterly and has generally been the highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers. Our Entertainment and Devices Division is particularly seasonal as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Typically, the Entertainment and Devices Division has generated approximately 40% of its yearly segment revenue in our second fiscal quarter.

Unearned Revenue Quarterly and annual revenue may be impacted by the deferral of revenue. See the discussions below regarding revenue deferred on: sales of Windows 7 with an option to upgrade to Windows 8 Pro at a discounted price (the "Windows Upgrade Offer") and pre-sales of Windows 8 to original equipment manufacturers ("OEMs") and retailers before general availability ("Windows 8 Pre-Sales") (collectively, the "Windows Deferral"); sales of the current version of the Microsoft Office system with a guarantee to be upgraded to the new Office at minimal or no cost (the "Office Upgrade Offer") and pre-sales of the new Office to OEMs and retailers before general availability ("Office Pre-Sales") (collectively, the "Office Deferral"); and on sales of video games with the right to receive specified software upgrades/enhancements (the "Video Game Deferral").

RESULTS OF OPERATIONS Summary (In millions, except percentages Three Months Ended Percentage Six Months Ended Percentage and per share amounts) December 31, Change December 31, Change ----------------------------------------------------------------------------------------------------------------------- - 2012 2011 2012 2011 Revenue $ 21,456 $ 20,885 3% $ 37,464 $ 38,257 (2)% Operating income $ 7,771 $ 7,994 (3)% $ 13,079 $ 15,197 (14)% Diluted earnings per share $ 0.76 $ 0.78 (3)% $ 1.28 $ 1.46 (12)%----------------------------------------------------------------------------------------------------------------------- - 33 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Three months ended December 31, 2012 compared with three months ended December 31, 2011 Revenue increased, primarily due to the launch of Windows 8 and Surface on October 26, 2012, and strong sales of Server and Tools products and services, offset in part by lower Entertainment and Devices revenue. During the three months ended December 31, 2012, we recognized a net $622 million of revenue related to the Windows Deferral, and we deferred a net $788 million of revenue related to the Office Deferral and $380 million of revenue related to the Video Game Deferral.

Operating income decreased, reflecting higher operating expenses, offset in part by revenue growth. Key changes in operating expenses were: • Sales and marketing expenses increased $547 million or 15%, primarily reflecting advertising of Windows 8 and Surface.

• Research and development expenses increased $157 million or 7%, due mainly to higher headcount-related expenses, primarily related to the Entertainment and Devices Division.

Six months ended December 31, 2012 compared with six months ended December 31, 2011 Revenue decreased, primarily due to the deferral of certain Office, Windows, and video game revenue and lower Entertainment and Devices revenue, offset in part by strong sales of Server and Tools products and services and the launch of Windows 8 and Surface. During the six months ended December 31, 2012, we deferred $977 million of revenue related to the Office Deferral, a net $545 million of revenue related to the Windows Deferral, and $380 million of revenue related to the Video Game Deferral.

Operating income decreased, reflecting lower revenue and increased cost of revenue and operating expenses. Key changes in cost of revenue and operating expenses were: • Sales and marketing expenses increased $592 million or 9%, primarily reflecting advertising of Windows 8 and Surface.

• Cost of revenue increased $445 million or 5%, reflecting payments made to Nokia related to joint strategic initiatives, higher headcount-related expenses, primarily related to Server and Tools, and increased product costs associated with Surface, offset in part by lower volumes of Xbox 360 consoles sold.

• Research and development expenses increased $288 million or 6%, due mainly to higher headcount-related expenses, primarily related to the Entertainment and Devices Division.

SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS) The revenue and operating income (loss) amounts in this section are presented on a basis consistent with accounting principles generally accepted in the U.S.

("U.S. GAAP") and include certain reconciling items attributable to each of the segments. Segment information appearing in Note 17 - Segment Information of the Notes to Financial Statements (Part I, Item I of this Form 10-Q) is presented on a basis consistent with our current internal management reporting. Certain corporate-level activity has been excluded from segment operating results and is analyzed separately. We have recast certain prior period amounts within this MD&A to conform to the way we internally managed and monitored segment performance during the current fiscal year.

Windows Division Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change ------------------------------------------------------------------------------------------------------------------------ - 2012 2011 2012 2011 Revenue $ 5,881 $ 4,741 24% $ 9,125 $ 9,615 (5)% Operating income $ 3,296 $ 2,880 14% $ 4,950 $ 6,161 (20)%------------------------------------------------------------------------------------------------------------------------ - Windows Division develops and markets PC operating systems, related software, and online services, and PC hardware products. This collection of software, hardware, and services is designed to simplify everyday tasks through seamless operations across the user's hardware and software. Windows Division offerings consist of the Windows operating system, software, and services, Surface, and Microsoft PC hardware products. The general availability of Surface, Windows 8, and Windows 8 and Windows RT devices started on October 26, 2012.

34 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Excluding the impact of the Windows Deferral, approximately 65% of total Windows Division revenue comes from Windows operating system software purchased by OEMs, which they pre-install on equipment they sell. The remaining Windows Division revenue is generated by commercial and retail sales of Windows, Surface, PC hardware products, and online advertising.

Three months ended December 31, 2012 compared with three months ended December 31, 2011 Windows Division revenue increased from the prior year, due in part to the recognition of a net $622 million of revenue related to Windows Deferral, as well as due to sales of Surface and Windows 8 upgrades. OEM revenue grew 17%, reflecting the net Windows Deferral recognition and increased demand in our distribution channels, offset in part by a decline in the x86 PC market.

Windows Division operating income increased, primarily due to revenue growth, offset in part by higher sales and marketing expenses and cost of revenue. Sales and marketing expenses increased $420 million or 49%, reflecting advertising costs associated with the launch of Windows 8 and Surface. Cost of revenue increased $293 million or 58%, including product costs associated with Surface and Windows 8 and Windows 8 upgrade support costs.

Six months ended December 31, 2012 compared with six months ended December 31, 2011 Windows Division revenue decreased from the prior year, due in part to the deferral of a net $545 million of revenue related to the Windows Upgrade Offer, as well as due to a decline in the x86 PC market and continued higher relative growth in emerging markets, where average selling prices are lower than developed markets. The revenue decrease was offset in part by sales of Surface and Windows 8 upgrades.

Windows Division operating income decreased, due mainly to lower revenue and higher sales and marketing expenses and cost of revenue. Sales and marketing expenses increased $368 million or 24%, reflecting advertising costs associated with the launch of Windows 8 and Surface. Cost of revenue increased $292 million or 30%, including product costs associated with Surface and Windows 8 and Windows 8 upgrade support costs.

Server and Tools Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change ----------------------------------------------------------------------------------------------------------------------- - 2012 2011 2012 2011 Revenue $ 5,186 $ 4,737 9% $ 9,739 $ 8,953 9% Operating income $ 2,121 $ 1,950 9% $ 3,858 $ 3,503 10%----------------------------------------------------------------------------------------------------------------------- - Server and Tools develops and markets technology and related services that enable information technology professionals and their systems to be more productive and efficient. Server and Tools product and service offerings include Windows Server, Microsoft SQL Server, Windows Azure, Visual Studio, System Center products, Windows Embedded device platforms, and Enterprise Services.

Enterprise Services comprise Premier product support services and Microsoft Consulting Services. We also offer developer tools, training, and certification.

Approximately 80% of Server and Tools revenue comes from product revenue, including purchases through volume licensing programs, licenses sold to OEMs, and retail packaged product, while the remainder comes from Enterprise Services.

Three months ended December 31, 2012 compared with three months ended December 31, 2011 Server and Tools revenue increased in both product sales and Enterprise Services. Product revenue increased $347 million or 9%, driven primarily by growth in SQL Server, Windows Server, and System Center, reflecting continued adoption of the Windows platform. Enterprise Services revenue grew $102 million or 10%, due to growth in both Premier product support and consulting services.

Server and Tools operating income increased, primarily due to revenue growth, offset in part by higher cost of revenue and sales and marketing expenses. Cost of revenue increased $163 million or 17%, primarily reflecting higher headcount-related expenses. Sales and marketing expenses grew $76 million or 7%, reflecting increased fees paid to third-party enterprise software advisors and corporate sales and marketing activities.

35 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Six months ended December 31, 2012 compared with six months ended December 31, 2011 Server and Tools revenue increased in both product sales and Enterprise Services. Product revenue increased $560 million or 8%, driven primarily by growth in SQL Server, System Center, and Windows Server, reflecting continued adoption of the Windows platform. Enterprise Services revenue grew $226 million or 12%, due to growth in both Premier product support and consulting services.

Server and Tools operating income increased, primarily due to revenue growth, offset in part by higher cost of revenue and sales and marketing expenses. Cost of revenue increased $273 million or 15%, primarily reflecting higher headcount-related expenses. Sales and marketing expenses grew $124 million or 6%, reflecting increased fees paid to third-party enterprise software advisors and corporate sales and marketing activities.

Online Services Division Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change -------------------------------------------------------------------------------------------------------------------------- - 2012 2011 2012 2011 Revenue $ 869 $ 784 11% $ 1,566 $ 1,425 10% Operating loss $ (283 ) $ (459 ) 38% $ (647 ) $ (973 ) 34%-------------------------------------------------------------------------------------------------------------------------- - Online Services Division ("OSD") develops and markets information and content designed to help people simplify tasks and make more informed decisions online, and to help advertisers connect with audiences. OSD offerings include Bing, Bing Ads, MSN, and advertiser tools. Bing and MSN generate revenue through the sale of search and display advertising, accounting for nearly all of OSD's annual revenue.

Three months ended December 31, 2012 compared with three months ended December 31, 2011 Online advertising revenue grew $109 million or 15% to $823 million, reflecting continued growth in search advertising revenue, offset in part by decreased display advertising revenue. Search revenue grew, primarily due to increased revenue per search. According to third-party sources, Bing organic U.S. market share for the month of December 2012 was approximately 16%, and grew 120 basis points year over year. Bing-powered U.S. market share, including Yahoo! properties, was approximately 26% for the month of December 2012, down 90 basis points year over year.

OSD's operating loss was reduced by higher revenue and lower cost of revenue and sales and marketing expenses. Cost of revenue decreased $72 million, driven by lower traffic acquisition costs and Yahoo! reimbursement costs. Sales and marketing expenses decreased $31 million or 16%, due mainly to decreased advertising and corporate marketing activities.

Six months ended December 31, 2012 compared with six months ended December 31, 2011 Online advertising revenue grew $193 million or 15% to $1.5 billion, reflecting continued growth in search advertising revenue, offset in part by decreased display advertising revenue. Search revenue grew, primarily due to increased revenue per search.

OSD's operating loss was reduced by higher revenue and lower cost of revenue and sales and marketing expenses, offset in part by higher research and development expenses. Cost of revenue decreased $163 million, driven by lower traffic acquisition costs and Yahoo! reimbursement costs. Sales and marketing expenses decreased $71 million or 19%, due mainly to decreased advertising and corporate marketing activities. Research and development expenses increased $47 million or 8%, primarily reflecting higher headcount-related expenses.

36 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Microsoft Business Division Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change ---------------------------------------------------------------------------------------------------------------------------- - 2012 2011 2012 2011 Revenue $ 5,691 $ 6,310 (10)% $ 11,192 $ 11,945 (6)% Operating income $ 3,565 $ 4,188 (15)% $ 7,214 $ 7,906 (9)%---------------------------------------------------------------------------------------------------------------------------- - Microsoft Business Division ("MBD") develops and markets software and online services designed to increase personal, team, and organization productivity. MBD offerings include the Microsoft Office system (comprising mainly Office, SharePoint, Exchange, Lync, and Office 365), which generates over 90% of MBD revenue, and Microsoft Dynamics business solutions. We evaluate MBD results based upon the nature of the end user in two primary parts: business revenue, which includes Microsoft Office system revenue generated through volume licensing agreements and Microsoft Dynamics revenue; and consumer revenue, which includes revenue from retail packaged product sales and OEM revenue.

Three months ended December 31, 2012 compared with three months ended December 31, 2011 MBD revenue decreased, due mainly to the deferral of $689 million of revenue related to the Office Upgrade Offer and $99 million of revenue related to Office Pre-Sales. This decrease was offset in part by overall increased sales of the Microsoft Office system. Business revenue increased $196 million or 4%, primarily reflecting growth in multi-year volume licensing revenue and a 12% increase in Microsoft Dynamics revenue. Consumer revenue decreased $815 million or 67%, driven primarily by the Office Deferral.

MBD revenue for the three months ended December 31, 2012 included an unfavorable foreign currency impact of $103 million.

MBD operating income decreased, mainly due to lower revenue.

Six months ended December 31, 2012 compared with six months ended December 31, 2011 MBD revenue decreased, due mainly to the deferral of $876 million of revenue related to the Office Upgrade Offer and $101 million of revenue related to Office Pre-Sales. This decrease was offset in part by overall increased sales of the Microsoft Office system. Business revenue increased $339 million or 4%, primarily reflecting growth in multi-year volume licensing revenue and an 11% increase in Microsoft Dynamics revenue. Consumer revenue decreased $1.1 billion or 47%, driven by the Office Deferral and a decline in the x86 PC market.

MBD revenue for the six months ended December 31, 2012 included an unfavorable foreign currency impact of $222 million.

MBD operating income decreased, mainly due to lower revenue, offset in part by lower research and development expenses. Research and development expenses decreased $78 million or 8%, primarily due to the capitalization of certain Microsoft Office system software development costs, offset in part by increased headcount-related expenses.

Entertainment and Devices Division Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change ----------------------------------------------------------------------------------------------------------------------------- - 2012 2011 2012 2011 Revenue $ 3,772 $ 4,238 (11)% $ 5,719 $ 6,200 (8)% Operating income $ 596 $ 517 15% $ 619 $ 860 (28)%----------------------------------------------------------------------------------------------------------------------------- - Entertainment and Devices Division ("EDD") develops and markets products and services designed to entertain and connect people. EDD offerings include the Xbox 360 entertainment platform (which includes the Xbox 360 gaming and entertainment console, Kinect for Xbox 360, Xbox 360 video games, Xbox LIVE, and Xbox 360 accessories), Mediaroom (our Internet protocol television software), Skype, and Windows Phone, including related patent licensing revenue. We acquired Skype on October 13, 2011, and its results of operations from that date are reflected in our results discussed below.

37 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Three months ended December 31, 2012 compared with three months ended December 31, 2011 EDD revenue decreased, primarily due to lower Xbox 360 platform revenue, offset in part by higher Windows Phone revenue. Xbox 360 platform revenue decreased $1.1 billion or 29%, due mainly to lower volumes of consoles sold and lower video game revenue, offset in part by higher Xbox LIVE revenue. We shipped 5.9 million Xbox 360 consoles during the second quarter of fiscal year 2013, compared with 8.2 million Xbox 360 consoles during the second quarter of fiscal year 2012. Video game revenue decreased, primarily due to $380 million of revenue deferred associated with the Video Game Deferral. Windows Phone revenue increased $546 million, including patent licensing revenue and increased sales of Windows Phone licenses.

EDD operating income increased, due mainly to lower cost of revenue and sales and marketing expenses, offset in part by decreased revenue and increased research and development expenses. Cost of revenue decreased $544 million or 19%, mainly due to decreased sales of Xbox 360 consoles, offset in part by payments made to Nokia related to joint strategic initiatives and increased royalties on Xbox LIVE content and video games. Sales and marketing expenses decreased $92 million or 21%, primarily reflecting decreased Xbox 360 platform marketing. Research and development expenses increased $98 million or 25%, primarily reflecting higher headcount-related expenses.

Six months ended December 31, 2012 compared with six months ended December 31, 2011 EDD revenue decreased, primarily due to lower Xbox 360 platform revenue, offset in part by higher Windows Phone revenue. Xbox 360 platform revenue decreased $1.5 billion or 27%, due mainly to lower volumes of consoles sold and lower video game revenue, offset in part by higher Xbox LIVE revenue. We shipped 7.5 million Xbox 360 consoles during the first half of fiscal year 2013, compared with 10.5 million Xbox 360 consoles during the first half of fiscal year 2012. Video game revenue decreased, primarily due to $380 million of revenue deferred associated with the Video Game Deferral. Windows Phone revenue increased $690 million, including patent licensing revenue and higher sales of Windows Phone licenses.

EDD operating income decreased, due mainly to lower revenue and higher research and development expenses, offset in part by lower cost of revenue and sales and marketing expenses. Research and development expenses increased $235 million or 33%, primarily reflecting higher headcount-related expenses. Cost of revenue decreased $392 million or 10%, mainly due to lower sales of Xbox 360 consoles, offset in part by payments made to Nokia related to joint strategic initiatives.

Sales and marketing expenses decreased $90 million or 14%, primarily reflecting decreased Xbox 360 platform marketing.

Corporate-Level Activity Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change -------------------------------------------------------------------------------------------------------------------------------------- - 2012 2011 2012 2011 Corporate-level activity $ (1,524 ) $ (1,082 ) (41)% $ (2,915 ) $ (2,260 ) (29)%-------------------------------------------------------------------------------------------------------------------------------------- - Certain corporate-level activity is not allocated to our segments, including costs of: broad-based sales and marketing; product support services; human resources; legal; finance; information technology; corporate development and procurement activities; research and development; costs of operating our retail stores; and legal settlements and contingencies.

Corporate-level expenses increased, due mainly to increased retail stores expenses, other increased headcount-related expenses, and higher intellectual property licensing costs.

38 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 COST OF REVENUE Cost of Revenue Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change ------------------------------------------------------------------------------------------------------------------------------- - 2012 2011 2012 2011 Cost of revenue $ 5,692 $ 5,638 1% $ 9,860 $ 9,415 5% As a percent of revenue 27 % 27 % 0ppt 26 % 25 % 1ppt------------------------------------------------------------------------------------------------------------------------------- - Cost of revenue includes: manufacturing and distribution costs for products sold, including Xbox and Surface, and programs licensed; operating costs related to product support service centers and product distribution centers; costs incurred to include software on PCs sold by OEMs, to drive traffic to our websites, and to acquire online advertising space ("traffic acquisition costs"); costs incurred to support and maintain Internet-based products and services including royalties; warranty costs; inventory valuation adjustments; costs associated with the delivery of consulting services; and the amortization of capitalized research and development costs.

Cost of revenue increased reflecting costs to manufacture Surface, higher headcount-related expenses, and payments made to Nokia related to joint strategic initiatives, offset in part by lower volumes of Xbox 360 consoles sold. Headcount-related expenses increased 17% and 13% for the three and six months ended December 31, 2012, respectively, primarily related to increased Server and Tools headcount.

OPERATING EXPENSES Research and Development Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change ------------------------------------------------------------------------------------------------------------------------------- - 2012 2011 2012 2011 Research and development $ 2,528 $ 2,371 7% $ 4,988 $ 4,700 6% As a percent of revenue 12 % 11 % 1ppt 13 % 12 % 1ppt------------------------------------------------------------------------------------------------------------------------------- - Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code.

Research and development expenses increased, reflecting an 8% and 5% increase in headcount-related expenses during the three and six months ended December 31, 2012, respectively, primarily related to the Entertainment and Devices Division.

Sales and Marketing Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change ------------------------------------------------------------------------------------------------------------------------------- - 2012 2011 2012 2011 Sales and marketing $ 4,309 $ 3,762 15% $ 7,254 $ 6,662 9% As a percent of revenue 20 % 18 % 2ppt 19 % 17 % 2ppt------------------------------------------------------------------------------------------------------------------------------- - Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel and the costs of advertising, promotions, trade shows, seminars, and other programs.

Sales and marketing expenses increased, primarily reflecting advertising of Windows 8 and Surface, and a 6% and 3% increase in headcount-related expenses during the three and six months ended December 31, 2012, respectively.

39 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 General and Administrative Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change -------------------------------------------------------------------------------------------------------------------------------- - 2012 2011 2012 2011 General and administrative $ 1,156 $ 1,120 3% $ 2,283 $ 2,283 0% As a percent of revenue 5 % 5 % 0ppt 6 % 6 % 0ppt-------------------------------------------------------------------------------------------------------------------------------- - General and administrative expenses include payroll, employee benefits, stock-based compensation expense, severance expense, and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative personnel, certain taxes, and legal and other administrative fees.

General and administrative expenses increased during the three months ended December 31, 2012, due primarily to higher legal charges.

OTHER INCOME (EXPENSE) AND INCOME TAXES Other Income (Expense) The components of other income (expense) were as follows: Three Months Ended Six Months Ended (In millions) December 31, December 31,-------------------------------------------------------------------------------------------------------- -- 2012 2011 2012 2011 Dividends and interest income $ 166 $ 182 $ 325 $ 393 Interest expense (105 ) (95 ) (200 ) (189 ) Net recognized gains on investments 43 315 28 318 Net losses on derivatives (65 ) (203 ) (61 ) (176 ) Net losses on foreign currency remeasurements (7 ) (4 ) (36 ) (44 ) Other (33 ) 50 169 46 -------------------------------------------------------------- -- - ------ -- - ------ -- - ------ -- Total $ (1 ) $ 245 $ 225 $ 348 -- ------ -- - ------ -- - ------ -- - ------ -- We use derivative instruments to: manage risks related to foreign currencies, equity prices, interest rates, and credit; enhance investment returns; and facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedges are recognized in other income (expense). These are generally offset by unrealized gains and losses in the underlying securities in the investment portfolio and are recorded as a component of other comprehensive income.

Three months ended December 31, 2012 compared with three months ended December 31, 2011 Net recognized gains on investments decreased, primarily due to lower gains on sales of equity and fixed-income securities, offset in part by lower other-than-temporary impairments. Net losses on derivatives decreased, due to lower losses on foreign currency derivatives and gains on equity derivatives in the current period as compared to losses in the comparable period, offset in part by losses on commodity and interest-rate derivatives in the current period as compared to gains in the comparable period.

Six months ended December 31, 2012 compared with six months ended December 31, 2011 Net recognized gains on investments decreased, primarily due to lower gains on sales of equity and fixed-income securities, offset in part by lower other-than-temporary impairments. Net losses on derivatives decreased, due to gains on commodity and equity derivatives in the current period as compared to losses in the comparable period, offset in part by higher losses on foreign currency derivatives and lower gains on interest-rate derivatives. For the six months ended December 31, 2012, other includes a gain recognized upon the divestiture of our 50% share in the MSNBC joint venture.

40 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Income Taxes Our effective tax rates were approximately 18% and 20% for the three months ended December 31, 2012 and 2011, respectively, and 18% and 20% for the six months ended December 31, 2012 and 2011, 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, which have lower income tax rates.

The current quarter effective tax rate is lower than our prior year's second quarter effective tax rate, primarily due to adjustments to prior year tax provision estimates and a favorable state court ruling. The current year effective tax rate is lower than our prior year effective tax rate, primarily due to the favorable impact of foreign currency exchange rate movements on our foreign tax provisions.

Tax contingencies and other tax liabilities were $7.7 billion and $7.6 billion as of December 31, 2012 and June 30, 2012, respectively, and are included in other long-term liabilities. While we settled a portion of the I.R.S. audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, we remain under audit for those 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, 2012, the primary unresolved issue relates to transfer pricing which could have a significant impact on our financial statements if not resolved favorably. We do not believe it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months, because 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 2011.

FINANCIAL CONDITION Cash, Cash Equivalents, and Investments Cash, cash equivalents, and short-term investments totaled $68.3 billion as of December 31, 2012, compared with $63.0 billion as of June 30, 2012. Equity and other investments were $10.7 billion as of December 31, 2012, compared with $9.8 billion as of June 30, 2012. Our short-term investments are primarily to facilitate liquidity and for capital preservation. They consist predominantly of highly liquid investment grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantly U.S.

dollar-denominated securities, but also include foreign currency-denominated securities in order to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are managed to achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid investment-grade fixed-income securities. While we own certain mortgage-backed and asset-backed fixed-income securities, our portfolio as of December 31, 2012 does not contain material direct exposure to subprime mortgages or structured vehicles that derive their value from subprime collateral. The majority of our mortgage-backed securities is collateralized by prime residential mortgages and carries a 100% principal and interest guarantee, primarily from Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and Government National Mortgage Association.

We routinely monitor our financial exposure to both sovereign and non-sovereign borrowers and counterparties. Our gross exposures to our customers and investments in Portugal, Italy, Ireland, Greece, and Spain are individually and collectively not material.

Of the cash, cash equivalents, and short-term investments at December 31, 2012, approximately $61 billion was held by our foreign subsidiaries and would be subject to material repatriation tax effects. The amount of cash and investments held by foreign subsidiaries subject to other restrictions on the free flow of funds (primarily currency and other local regulatory) was approximately $579 million. As of December 31, 2012, approximately 84% of the short-term investments held by our foreign subsidiaries were invested in U.S. government and agency securities, approximately 5% were invested in corporate notes and bonds of U.S. companies, and 3% were invested in U.S. mortgage-backed securities, all of which are denominated in U.S. dollars.

Securities lending We lend certain fixed-income and equity securities to increase investment returns. The loaned securities continue to be carried as investments on our balance sheet. Cash and/or security interests are received as collateral for the loaned securities with the amount determined based upon the underlying security lent and the creditworthiness of the 41 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 borrower. Cash received is recorded as an asset with a corresponding liability.

Our securities lending payable balance was $21 million as of December 31, 2012.

Our average and maximum securities lending payable balances for the three months ended December 31, 2012 were $174 million and $455 million, respectively. Our average and maximum securities lending payable balances for the six months ended December 31, 2012 were $509 million and $1.4 billion, respectively.

Intra-quarter variances in the amount of securities loaned are mainly due to fluctuations in the demand for the securities.

Valuation In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our financial instruments. This pricing methodology applies to our Level 1 investments, such as exchange-traded mutual funds, domestic and international equities, and U.S.

treasuries. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments such as corporate notes and bonds, foreign government bonds, mortgage-backed securities, and agency securities. Level 3 investments are valued using internally developed models with unobservable inputs. Assets and liabilities measured using unobservable inputs are an immaterial portion of our portfolio.

A majority of our investments are priced by pricing vendors and are generally Level 1 or Level 2 investments as these vendors either provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted price is not available, the investment is not priced by our pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally labeled as Level 2 investments because the broker prices these investments based on similar assets without applying significant adjustments. In addition, all of our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these investments. Our fair value processes include controls that are designed to ensure appropriate fair values are recorded. These controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and independent recalculation of prices where appropriate.

Cash Flows Cash flows from operations decreased $1.1 billion to $13.3 billion for the six months ended December 31, 2012, due mainly to changes in working capital, including increases in inventory and other current assets, offset in part by increased cash collections from customers. Cash used in financing decreased $1.4 billion to $3.9 billion, due mainly to $2.2 billion in proceeds from issuance of debt, offset in part by a $585 million increase in dividends paid and a $314 million increase in cash used for common stock repurchases. Cash used in investing increased $2.4 billion to $10.3 billion, due mainly to a $9.4 billion increase in cash used for net investment purchases, maturities, and sales and a $599 million increase in cash used for additions to property and equipment, offset in part by an $8.0 billion decrease in cash used for acquisitions of companies and intangible and other assets.

Debt We issued debt to take advantage of favorable pricing and liquidity in the debt markets, reflecting our credit rating and the low interest rate environment. The proceeds of these issuances were or will be used to partially fund discretionary business acquisitions, share repurchases, and other general corporate purposes.

As of December 31, 2012, the total carrying value and estimated fair value of our long-term debt, including the current portion, were $14.2 billion and $15.2 billion, respectively. This is compared to a carrying value and estimated fair value of $11.9 billion and $13.2 billion, respectively, as of June 30, 2012.

These estimated fair values are based on Level 2 inputs.

42 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 The components of our long-term debt, including the current portion, and the associated interest rates were as follows as of December 31, 2012: Stated Effective Interest Interest Due Date Face Value Rate Rate ------------------------------------------------------------------------ -- (In millions) Notes September 27, 2013 $ 1,000 0.875 % 1.000 % June 1, 2014 2,000 2.950 % 3.049 % September 25, 2015 1,750 1.625 % 1.795 % February 8, 2016 750 2.500 % 2.642 % November 15, 2017 (a) 600 0.875 % 1.084 % June 1, 2019 1,000 4.200 % 4.379 % October 1, 2020 1,000 3.000 % 3.137 % February 8, 2021 500 4.000 % 4.082 % November 15, 2022 (a) 750 2.125 % 2.239 % June 1, 2039 750 5.200 % 5.240 % October 1, 2040 1,000 4.500 % 4.567 % February 8, 2041 1,000 5.300 % 5.361 % November 15, 2042 (a) 900 3.500 % 3.571 % --------------------------------------- - Total 13,000 Convertible Debt June 15, 2013 1,250 0.000 % 1.849 % --------------------------------------- - Total $ 14,250 --- ----------- - (a) In November 2012, we issued $2.25 billion of debt securities. The notes are senior unsecured obligations and rank equally with our other unsecured and unsubordinated debt outstanding.

Interest on the notes is paid semi-annually. As of December 31, 2012, the aggregate unamortized discount for our long-term debt, including the current portion, was $62 million.

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

Convertible Debt In June 2010, we issued $1.25 billion of zero coupon convertible unsecured debt due on June 15, 2013 in a private placement offering. Proceeds from the offering were $1.24 billion, net of fees and expenses, which were capitalized. Initially, each $1,000 principal amount of notes was convertible into 29.94 shares of Microsoft common stock at a conversion price of $33.40 per share. The conversion ratio is adjusted periodically for dividends in excess of the initial dividend threshold as defined in the debt agreement. As of December 31, 2012, the net carrying amount of our convertible debt was $1.2 billion and the unamortized discount was $9 million.

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

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

43 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 In connection with issuance of the notes, we entered into capped call transactions with certain option counterparties who are initial purchasers of the notes or their affiliates. The capped call transactions are expected to reduce potential dilution of earnings per share upon conversion of the notes.

Under the capped call transactions, we purchased from the option counterparties capped call options that in the aggregate relate to the total number of shares of our common stock underlying the notes, with a strike price equal to the conversion price of the notes and with an initial cap price equal to $37.16, which is adjusted periodically to mirror any adjustments to the conversion price. The purchased capped calls were valued at $40 million and recorded to stockholders' equity.

Unearned Revenue Unearned revenue at December 31, 2012 comprised mainly unearned revenue from volume licensing programs. Unearned revenue from volume licensing programs represents customer billings for multi-year licensing arrangements paid for either at inception of the agreement or annually at the beginning of each billing coverage period and accounted for as subscriptions with revenue recognized ratably over the billing coverage period. Unearned revenue at December 31, 2012 also included payments for: the Windows Upgrade Offer; post-delivery support and consulting services to be performed in the future; the Office Deferral; Xbox LIVE subscriptions and prepaid points; the Video Game Deferral; Microsoft Dynamics business solutions products; Skype prepaid credits and subscriptions; OEM minimum commitments; and other offerings for which we have been paid in advance and earn the revenue when we provide the service or software, or otherwise meet the revenue recognition criteria.

The following table outlines the expected future recognition of unearned revenue as of December 31, 2012: (In millions) -------------------------------- - Three Months Ending, March 31, 2013 $ 9,055 June 30, 2013 5,489 September 30, 2013 2,521 December 31, 2013 1,289 Thereafter 1,459 -------------------------------- - Total $ 19,813 - ------- - Share Repurchase Program During the three and six months ended December 31, 2012, we repurchased approximately 58 million and 91 million shares of Microsoft common stock for $1.6 billion and $2.6 billion, respectively, under the repurchase program we announced on September 22, 2008. All repurchases were made using cash resources.

As of December 31, 2012, approximately $5.6 billion remained of the $40.0 billion approved repurchase amount. The repurchase program expires September 30, 2013 but may be suspended or discontinued at any time without notice.

Dividends Our Board of Directors declared the following dividends during the periods presented: Dividend Declaration Date Per Share Record Date Total Amount Payment Date------------------------------------------------------------------------------------------------------------- - (in millions) Fiscal Year 2013 September 18, 2012 $ 0.23 November 15, 2012 $ 1,933 December 13, 2012 November 28, 2012 $ 0.23 February 21, 2013 $ 1,926 March 14, 2013 Fiscal Year 2012 September 20, 2011 $ 0.20 November 17, 2011 $ 1,683 December 8, 2011 December 14, 2011 $ 0.20 February 16, 2012 $ 1,683 March 8, 2012 ------------------------------------------------------------------------------------------------------------- - 44 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Off-Balance Sheet Arrangements We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. In evaluating estimated losses on these indemnifications, we consider factors such as the degree of probability of an unfavorable outcome and our ability to make a reasonable estimate of the amount of loss. These obligations did not have a material impact on our financial statements during the periods presented.

Other Planned Uses of Capital We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology. Additions to property and equipment will continue, including new facilities, data centers, and computer systems for research and development, sales and marketing, support, and administrative staff. We have operating leases for most U.S. and international sales and support offices and certain equipment. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital resources.

Liquidity We earn a significant amount of our operating income outside the U.S., which is deemed to be permanently reinvested in foreign jurisdictions. As a result, as discussed above under Cash, Cash Equivalents, and Investments, the majority of our cash, cash equivalents, and short-term investments is held by foreign subsidiaries. We currently do not intend nor foresee a need to repatriate these funds. We expect existing domestic cash, cash equivalents, short-term investments, and cash flows from operations to continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, such as regular quarterly dividends, debt repayment schedules, and material capital expenditures, for at least the next 12 months and thereafter for the foreseeable future. In addition, we expect existing foreign cash, cash equivalents, short-term investments, and cash flows from operations to continue to be sufficient to fund our foreign operating activities and cash commitments for investing activities, such as material capital expenditures, for at least the next 12 months and thereafter for the foreseeable future.

Should we require more capital in the U.S. than is generated by our operations domestically, for example to fund significant discretionary activities, such as business acquisitions and share repurchases, we could elect to repatriate future earnings from foreign jurisdictions or raise capital in the U.S. through debt or equity issuances. These alternatives could result in higher effective tax rates, increased interest expense, or dilution of our earnings. We have borrowed funds domestically and continue to believe we have the ability to do so at reasonable interest rates.

RECENT ACCOUNTING GUIDANCE Recently Adopted Accounting Guidance In September 2011, the Financial Accounting Standards Board ("FASB") issued guidance on testing goodwill for impairment. The new guidance provides an entity the option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If an entity determines that this is the case, it is required to perform the currently prescribed two-step goodwill impairment test to identify potential goodwill impairment and measure the amount of goodwill impairment loss to be recognized for that reporting unit (if any). If an entity determines that the fair value of a reporting unit is greater than its carrying amount, the two-step goodwill impairment test is not required. We adopted this new guidance beginning July 1, 2012. Adoption of this new guidance did not have a material impact on our financial statements.

In June 2011, the FASB issued guidance on presentation of comprehensive income. The new guidance eliminated the option to report other comprehensive income and its components in the statement of changes in stockholders' equity. Instead, an entity is required to present either a continuous statement of net income and other comprehensive income or in two separate but consecutive statements. The new guidance also required entities to present reclassification adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which other comprehensive income is presented. This guidance was amended in December 2011 when the FASB issued guidance which indefinitely defers presentation of reclassification adjustments. We adopted this new amended guidance beginning July 1, 2012. Adoption of this new amended guidance resulted only in changes to presentation of our financial statements.

45 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Recent Accounting Guidance Not Yet Adopted In December 2011, the FASB issued guidance enhancing disclosure requirements about the nature of an entity's right to offset and related arrangements associated with its financial instruments and derivative instruments. The new guidance requires the disclosure of the gross amounts subject to rights of set-off, amounts offset in accordance with the accounting standards followed, and the related net exposure. The new guidance will be effective for us beginning July 1, 2013. Other than requiring additional disclosures, we do not anticipate material impacts on our financial statements upon adoption.

APPLICATION OF CRITICAL ACCOUNTING POLICIES Our financial statements and accompanying notes are prepared in accordance with U.S. GAAP. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management's application of accounting policies. Critical accounting policies for us include revenue recognition, impairment of investment securities, goodwill, research and development costs, contingencies, income taxes, and stock-based compensation.

Revenue Recognition Software revenue recognition requires judgment, including whether a software arrangement includes multiple elements, and if so, whether vendor-specific objective evidence ("VSOE") of fair value exists for those elements. A portion of revenue may be recorded as unearned due to undelivered elements. Changes to the elements in a software arrangement, the ability to identify VSOE for those elements, and the fair value of the respective elements could materially impact the amount of earned and unearned revenue. Judgment is also required to assess whether future releases of certain software represent new products or upgrades and enhancements to existing products.

Windows 7 revenue is subject to deferral as a result of the Windows Upgrade Offer, which started June 2, 2012. The offer provides significantly discounted rights to purchase Windows 8 Pro to qualifying end-users that purchase Windows 7 PCs during the eligibility period. Microsoft is responsible for delivering Windows 8 Pro to the end customer. Accordingly, revenue related to the allocated discount for undelivered Windows 8 is deferred until it is delivered or the redemption period expires.

Microsoft Office system revenue is subject to deferral as a result of the Office Upgrade Offer, which started October 19, 2012. The Office Upgrade Offer allows customers who purchase qualifying 2010 Microsoft Office system or Office for Mac 2011 products to receive, at no cost, a one-year subscription to Office 365 Home Premium or the equivalent version of 2013 Microsoft Office system upon general availability. Small business customers in applicable markets will also be eligible for a three-month trial of Office 365 Small Business Premium.

Accordingly, estimated revenue related to the undelivered 2013 Microsoft Office system and subscription services is deferred until the products and services are delivered or the redemption period expires.

Impairment of Investment Securities We review investments quarterly for indicators of other-than-temporary impairment. This determination requires significant judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to sell, the investment. For fixed-income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded to other income (expense) and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments.

Goodwill We allocate goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative 46 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 fair value allocation approach. Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit.

Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated using a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital.

The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market conditions, and other factors.

Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit.

Research and Development Costs Costs incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, all software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to manufacturing. The amortization of these costs is included in cost of revenue over the estimated life of the products.

Legal and Other Contingencies The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency such as a legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. Disclosure of a contingency is required if there is at least a reasonable possibility that a loss has been incurred. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our financial statements.

Income Taxes The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity's financial statements or tax returns. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Accounting literature also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our financial statements.

Stock-Based Compensation Stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense, net of estimated forfeitures, over the requisite service period. Determining the fair value of stock-based awards at the grant date requires judgment, including estimating expected dividends. In addition, judgment is also required in estimating the amount of stock-based awards that are expected to be forfeited. If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations could be impacted.

47 -------------------------------------------------------------------------------- Table of Contents PART I Item 3

[ Back To LatinAmerica.tmcnet.com's Homepage 's Homepage ]

comments powered by Disqus




Technology Marketing Corporation

800 Connecticut Ave, 1st Floor East, Norwalk, CT 06854 USA
Ph: 800-243-6002, 203-852-6800
Fx: 203-866-3326

General comments: tmc@tmcnet.com.
Comments about this site: webmaster@tmcnet.com.

STAY CURRENT YOUR WAY

© 2014 Technology Marketing Corporation. All rights reserved | Privacy Policy