Edgar Filing: MICROSOFT CORP

Quarterly Report on Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the Quarterly Period Ended December 31, 2009

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

For the Transition Period From to

Commission File Number: 0-14278

MICROSOFT CORPORATION

(Exact name of registrant as specified in its charter)


Washington		91-1144442
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

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

(425) 882-8080

(Registrant’s telephone number, including area code)

None

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

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

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

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


Large accelerated filer x		Accelerated filer ¨
Non-accelerated filer ¨ (Do not check if a smaller reporting company)		Smaller reporting company ¨

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

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


Class		Outstanding at January 25, 2010


Common Stock, $0.00000625 par value per share		8,770,460,922 shares

MICROSOFT CORPORATION

FORM 10-Q

For the Quarter Ended December 31, 2009

INDEX


				Page
PART I.	FINANCIAL INFORMATION

	Item 1.	Financial Statements

		a)	Income Statements for the Three and Six Months Ended December 31, 2009 and 2008	3

		b)	Balance Sheets as of December 31, 2009 and June 30, 2009	4

		c)	Cash Flows Statements for the Three and Six Months Ended December 31, 2009 and 2008	5

		d)	Stockholders’ Equity Statements for the Three and Six Months Ended December 31, 2009 and 2008	6

		e)	Notes to Financial Statements	7

		f)	Report of Independent Registered Public Accounting Firm	26

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		27

	Item 3.	Quantitative and Qualitative Disclosures About Market Risk		42

	Item 4.	Controls and Procedures		43

PART II.	OTHER INFORMATION

	Item 1.	Legal Proceedings		43

	Item 1A.	Risk Factors		44

	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		49

	Item 4.	Submission of Matters to a Vote of Security Holders		49

	Item 6.	Exhibits		51

SIGNATURE				52


PAGE		2

PART I

Item 1

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

INCOME STATEMENTS


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


	2009		2008			2009		2008

Revenue	$	19,022	$	16,629		$	31,942	$	31,690
Operating expenses:
Cost of revenue		3,628		3,907			6,470		6,755
Research and development		2,079		2,290			4,144		4,573
Sales and marketing		3,619		3,662			6,409		6,706
General and administrative		1,124		831			1,865		1,718
Employee severance		59		—			59		—

Total operating expenses		10,509		10,690			18,947		19,752

Operating income		8,513		5,939			12,995		11,938
Other income (expense)		370		(301	)		653		(309	)

Income before income taxes		8,883		5,638			13,648		11,629
Provision for income taxes		2,221		1,464			3,412		3,082

Net income	$	6,662	$	4,174		$	10,236	$	8,547


Earnings per share:
Basic	$	0.75	$	0.47		$	1.15	$	0.95
Diluted	$	0.74	$	0.47		$	1.14	$	0.94

Weighted average shares outstanding:
Basic		8,856		8,903			8,885		8,994
Diluted		8,951		8,914			8,975		9,052

Cash dividends declared per common share	$	0.13	$	0.13		$	0.26	$	0.26

See accompanying notes.


PAGE		3

PART I

Item 1

BALANCE SHEETS


(In millions)	December 31,			June 30,


2009					2009	⁽¹⁾
	(Unaudited)
Assets
Current assets:
Cash and cash equivalents	$	9,422		$	6,076
Short-term investments (including securities loaned of $2,654 and $1,540)		26,677			25,371

Total cash, cash equivalents, and short-term investments		36,099			31,447
Accounts receivable, net of allowance for doubtful accounts of $506 and $451		11,196			11,192
Inventories		589			717
Deferred income taxes		2,056			2,213
Other		2,547			3,711

Total current assets		52,487			49,280
Property and equipment, net of accumulated depreciation of $8,170 and $7,547		7,402			7,535
Equity and other investments		6,976			4,933
Goodwill		12,368			12,503
Intangible assets, net		1,346			1,759
Deferred income taxes		—			279
Other long-term assets		1,517			1,599

Total assets	$	82,096		$	77,888

Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	$	3,171		$	3,324
Short-term debt		2,249			2,000
Accrued compensation		2,417			3,156
Income taxes		721			725
Short-term unearned revenue		11,361			13,003
Securities lending payable		2,911			1,684
Other		2,885			3,142

Total current liabilities		25,715			27,034
Long-term debt		3,746			3,746
Long-term unearned revenue		1,167			1,281
Deferred income taxes		377			—
Other long-term liabilities		6,808			6,269
Commitments and contingencies
Stockholders’ equity:
Common stock and paid-in capital—shares authorized 24,000; outstanding 8,811 and 8,908		62,566			62,382
Retained deficit, including accumulated other comprehensive income of $1,322 and $969		(18,283	)		(22,824	)

Total stockholders’ equity		44,283			39,558

Total liabilities and stockholders’ equity	$	82,096		$	77,888

(1)	Derived from audited financial statements.

See accompanying notes.


PAGE		4

PART I

Item 1

CASH FLOWS STATEMENTS


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


	2009			2008			2009			2008

Operations
Net income	$	6,662		$	4,174		$	10,236		$	8,547
Adjustments to reconcile net income to net cash from operations:
Depreciation, amortization, and other noncash items		615			632			1,261			1,217
Stock-based compensation		485			417			928			860
Net recognized losses (gains) on investments and derivatives		(188	)		139			(254	)		175
Excess tax benefits from stock-based compensation		(15	)		(2	)		(24	)		(46	)
Deferred income taxes		550			454			504			830
Deferral of unearned revenue		6,926			5,969			13,605			10,155
Recognition of unearned revenue		(9,126	)		(6,364	)		(15,363	)		(12,408	)
Changes in operating assets and liabilities:
Accounts receivable		(2,789	)		(1,647	)		(41	)		2,338
Other current assets		1,244			797			590			239
Other long-term assets		16			(69	)		(62	)		(185	)
Other current liabilities		285			614			(954	)		(3,938	)
Other long-term liabilities		304			668			650			1,368

Net cash from operations		4,969			5,782			11,076			9,152

Financing
Short-term borrowings (repayments), maturities of 90 days or less, net		(475	)		21			(97	)		1,996
Proceeds from issuance of debt, maturities longer than 90 days		1,046			—			1,741			—
Repayments of debt, maturities longer than 90 days		(573	)		—			(1,396	)		—
Common stock issued		729			96			977			324
Common stock repurchased		(3,867	)		(2,820	)		(5,407	)		(9,313	)
Common stock cash dividends		(1,152	)		(1,157	)		(2,309	)		(2,155	)
Excess tax benefits from stock-based compensation		15			2			24			46

Net cash used in financing		(4,277	)		(3,858	)		(6,467	)		(9,102	)

Investing
Additions to property and equipment		(376	)		(842	)		(811	)		(1,620	)
Acquisition of companies, net of cash acquired		(63	)		(450	)		(102	)		(827	)
Purchases of investments		(4,287	)		(6,596	)		(14,777	)		(10,842	)
Maturities of investments		1,896			290			5,394			754
Sales of investments		3,361			5,700			7,778			12,775
Securities lending payable		(623	)		(601	)		1,227			(2,144	)

Net cash used in investing		(92	)		(2,499	)		(1,291	)		(1,904	)
Effect of exchange rates on cash and cash equivalents		(1	)		(83	)		28			(139	)

Net change in cash and cash equivalents		599			(658	)		3,346			(1,993	)
Cash and cash equivalents, beginning of period		8,823			9,004			6,076			10,339

Cash and cash equivalents, end of period	$	9,422		$	8,346		$	9,422		$	8,346

See accompanying notes.


PAGE		5

PART I

Item 1

STOCKHOLDERS’ EQUITY STATEMENTS


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


	2009			2008			2009			2008

Common stock and paid-in capital
Balance, beginning of period	$	62,293		$	61,655		$	62,382		$	62,849
Common stock issued		779			86			1,027			312
Common stock repurchased		(923	)		(674	)		(1,656	)		(2,571	)
Stock-based compensation		485			417			928			860
Stock-based compensation income tax deficiencies		(68	)		(91	)		(114	)		(58	)
Other, net		—			(1	)		(1	)		—

Balance, end of period		62,566			61,392			62,566			61,392

Retained deficit
Balance, beginning of period		(21,081	)		(28,061	)		(22,824	)		(26,563	)
Net income		6,662			4,174			10,236			8,547
Other comprehensive income:
Net unrealized gains (losses) on derivatives		(42	)		473			(361	)		766
Net unrealized gains (losses) on investments		65			(514	)		653			(912	)
Translation adjustments and other		(35	)		(251	)		61			(409	)

Comprehensive income		6,650			3,882			10,589			7,992
Common stock cash dividends		(1,140	)		(1,147	)		(2,297	)		(2,304	)
Common stock repurchased		(2,712	)		(1,588	)		(3,751	)		(6,039	)

Balance, end of period		(18,283	)		(26,914	)		(18,283	)		(26,914	)

Total stockholders’ equity	$	44,283		$	34,478		$	44,283		$	34,478

See accompanying notes.


PAGE		6

PART I

Item 1

NOTES TO FINANCIAL STATEMENTS

(Unaudited)

NOTE 1 ACCOUNTING POLICIES

Basis of Presentation

In the opinion of management, the accompanying balance sheets and related interim statements of income, cash flows, and stockholders’ equity include all adjustments, consisting only of normal recurring items, necessary for their fair presentation in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”). Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples include: estimates of loss contingencies, product warranties, product life cycles, product returns, and stock-based compensation forfeiture rates; assumptions such as the elements comprising a software arrangement, including the distinction between upgrades/enhancements and new products; when technological feasibility is achieved for our products; the potential outcome of future tax consequences of events that have been recognized in our financial statements or tax returns; estimating the fair value and/or goodwill impairment for our reporting units; and determining when investment impairments are other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions.

Interim results are not necessarily indicative of results for a full year. The information included in this Form 10-Q should be read in conjunction with information included in the Microsoft Corporation 2009 Form 10-K filed on July 30, 2009 with the U.S. Securities and Exchange Commission.

Principles of Consolidation

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

Subsequent Events

We evaluated events occurring between the end of our fiscal quarter, December 31, 2009 and January 28, 2010 when the financial statements were issued.

Recently Adopted Accounting Guidance

On July 1, 2009, we adopted guidance issued by the Financial Accounting Standards Board (“FASB”) on business combinations. The guidance retains the fundamental requirements that the acquisition method of accounting (previously referred to as the purchase method of accounting) be used for all business combinations, but requires a number of changes, including changes in the way assets and liabilities are recognized and measured as a result of business combinations. It also requires the capitalization of in-process research and development at fair value and requires the expensing of acquisition-related costs as incurred. We have applied this guidance to business combinations completed since July 1, 2009.

On July 1, 2009, we adopted the guidance issued by the FASB that changes the accounting and reporting for non-controlling interests. Non-controlling interests are to be reported as a component of equity separate from the parent’s equity, and purchases or sales of equity interests that do not result in a change in control are to be accounted for as equity transactions. In addition, net income attributable to a non-controlling interest is to be included in net income and, upon a loss of control, the interest sold, as well as any interest retained, is to be recorded at fair value with any gain or loss recognized in net income. Adoption of the new guidance did not have a material impact on our financial statements.

On July 1, 2009, we adopted the guidance on fair value measurement for nonfinancial assets and liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). Adoption of the new guidance did not have a material impact on our financial statements.


PAGE		7

PART I

Item 1

Recent Accounting Guidance Not Yet Adopted

In January 2010, the FASB issued guidance to amend the disclosure requirements related to recurring and nonrecurring fair value measurements. The guidance requires new disclosures on the transfers of assets and liabilities between Level 1 (quoted prices in active market for identical assets or liabilities) and Level 2 (significant other observable inputs) of the fair value measurement hierarchy, including the reasons and the timing of the transfers. Additionally, the guidance requires a roll forward of activities on purchases, sales, issuance, and settlements of the assets and liabilities measured using significant unobservable inputs (Level 3 fair value measurements). The guidance will become effective for us with the reporting period beginning January 1, 2010, except for the disclosure on the roll forward activities for Level 3 fair value measurements, which will become effective for us with the reporting period beginning July 1, 2011. Other than requiring additional disclosures, adoption of this new guidance will not have a material impact on our financial statements.

In October 2009, the FASB issued guidance on revenue recognition that will become effective for us beginning July 1, 2010, with earlier adoption permitted. Under the new guidance on arrangements that include software elements, tangible products that have software components that are essential to the functionality of the tangible product will no longer be within the scope of the software revenue recognition guidance, and software-enabled products will now be subject to other relevant revenue recognition guidance. Additionally, the FASB issued guidance on revenue arrangements with multiple deliverables that are outside the scope of the software revenue recognition guidance. Under the new guidance, when vendor specific objective evidence or third party evidence for deliverables in an arrangement cannot be determined, a best estimate of the selling price is required to separate deliverables and allocate arrangement consideration using the relative selling price method. The new guidance includes new disclosure requirements on how the application of the relative selling price method affects the timing and amount of revenue recognition. We believe adoption of this new guidance will not have a material impact on our financial statements.

In June 2009, the FASB issued guidance on the consolidation of variable interest entities, which is effective for us beginning July 1, 2010. The new guidance requires revised evaluations of whether entities represent variable interest entities, ongoing assessments of control over such entities, and additional disclosures for variable interests. We believe adoption of this new guidance will not have a material impact on our financial statements.

NOTE 2 EARNINGS PER SHARE

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


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


	2009		2008		2009		2008

Net income available for common shareholders (A)	$	6,662	$	4,174	$	10,236	$	8,547

Weighted average shares of common stock outstanding (B)		8,856		8,903		8,885		8,994
Dilutive effect of stock-based awards		95		11		90		58

Common stock and common stock equivalents (C)		8,951		8,914		8,975		9,052

Earnings per share:
Basic (A/B)	$	0.75	$	0.47	$	1.15	$	0.95
Diluted (A/C)	$	0.74	$	0.47	$	1.14	$	0.94

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

(In millions)

Three Months Ended
December 31,

Six Months Ended
December 31,

2009

2008

2009

2008

Shares excluded from calculations of diluted EPS

101

517

155

326


PAGE		8

PART I

Item 1

NOTE 3 OTHER INCOME (EXPENSE)

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


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


	2009			2008			2009		2008

Dividends and interest	$	159		$	175		$	324	$	382
Net recognized gains on investments		92			270			162		399
Net gains (losses) on derivatives		96			(409	)		92		(574	)
Net gains (losses) on foreign currency remeasurements		(23	)		(350	)		32		(529	)
Other		46			13			43		13

Total	$	370		$	(301	)	$	653	$	(309	)

Other-than-temporary impairments included in net recognized gains on investments were $6 million and $24 million for the three months and six months ended December 31, 2009, respectively, as compared with $262 million and $334 million during the three months and six months ended December 31, 2008, respectively.

NOTE 4 INVESTMENTS

Investment Components

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


(In millions)	Cost Basis		Unrealized Gains		Unrealized Losses			Recorded Basis		Cash and Cash Equivalents		Short-term Investments		Equity and Other Investments


December 31, 2009

Cash	$	2,151	$	—	$	—		$	2,151	$	2,151	$	—	$	—
Mutual funds		1,713		—		—			1,713		1,662		51		—
Commercial paper		2,440		—		—			2,440		1,816		624		—
Certificates of deposit		3,292		—		—			3,292		3,058		234		—
U.S. government and agency securities		12,542		50		(9	)		12,583		415		12,168		—
Foreign government bonds		3,530		84		(3	)		3,611		—		3,611		—
Mortgage-backed securities		3,981		91		(4	)		4,068		—		4,068		—
Corporate notes and bonds		5,411		288		(14	)		5,685		200		5,485		—
Municipal securities		539		1		(2	)		538		120		418		—
Common and preferred stock		5,171		1,432		(116	)		6,487		—		—		6,487
Other investments		507		—		—			507		—		18		489

Total	$	41,277	$	1,946	$	(148	)	$	43,075	$	9,422	$	26,677	$	6,976


PAGE		9

PART I

Item 1


(In millions)	Cost Basis		Unrealized Gains		Unrealized Losses			Recorded Basis		Cash and Cash Equivalents		Short-term Investments			Equity and Other Investments


June 30, 2009

Cash	$	2,064	$	—	$	—		$	2,064	$	2,064	$	—		$	—
Mutual funds		1,007		—		(25	)		982		900		82			—
Commercial paper		2,601		—		—			2,601		400		2,201			—
Certificates of deposit		555		—		—			555		275		280			—
U.S. government and agency securities		13,450		21		(5	)		13,466		2,369		11,097			—
Foreign government bonds		3,450		71		(4	)		3,517		—		3,517			—
Mortgage-backed securities		3,353		81		(16	)		3,418		—		3,418			—
Corporate notes and bonds		4,361		287		(52	)		4,596		—		4,596			—
Municipal securities		255		2		(1	)		256		68		188			—
Common and preferred stock		4,015		627		(182	)		4,460		—		—			4,460
Other investments		465		—		—			465		—		(8	)		473

Total	$	35,576	$	1,089	$	(285	)	$	36,380	$	6,076	$	25,371		$	4,933

Unrealized Losses on Investments

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


	Less than 12 Months					12 Months or Greater							Total Unrealized Losses

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


December 31, 2009

U.S. government and agency securities	$	568	$	(9	)	$	—	$	—		$	568	$	(9	)
Foreign government bonds		1,395		(1	)		491		(2	)		1,886		(3	)
Mortgage-backed securities		391		(2	)		20		(2	)		411		(4	)
Corporate notes and bonds		397		(5	)		183		(9	)		580		(14	)
Municipal securities		110		(2	)		—		—			110		(2	)
Common and preferred stock		887		(58	)		243		(58	)		1,130		(116	)

Total	$	3,748	$	(77	)	$	937	$	(71	)	$	4,685	$	(148	)


	Less than 12 Months					12 Months or Greater							Total Unrealized Losses

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


June 30, 2009

Mutual funds	$	3	$	(1	)	$	77	$	(24	)	$	80	$	(25	)
U.S. government and agency securities		4,033		(5	)		—		—			4,033		(5	)
Foreign government bonds		1,444		(3	)		669		(1	)		2,113		(4	)
Mortgage-backed securities		503		(16	)		—		—			503		(16	)
Corporate notes and bonds		713		(10	)		504		(42	)		1,217		(52	)
Municipal securities		16		(1	)		—		—			16		(1	)
Common and preferred stock		1,154		(135	)		120		(47	)		1,274		(182	)

Total	$	7,866	$	(171	)	$	1,370	$	(114	)	$	9,236	$	(285	)

At December 31, 2009 and June 30, 2009, the recorded bases and estimated fair values of common and preferred stock and other investments that are restricted for more than one year or are not publicly traded were $209 million and $204 million, respectively. The estimated fair values are based on publicly available market information or other estimates determined by management. Unrealized losses on fixed-income securities are primarily attributable to


PAGE		10

PART I

Item 1

changes in interest rates. Unrealized losses on domestic and international equities are due to market price movements. Management does not believe any remaining unrealized losses represent other-than-temporary impairments based on our evaluation of available evidence as of December 31, 2009.

Debt Investment Maturities


(In millions)	Cost Basis		Estimated Fair Value

Due in one year or less	$	9,837	$	9,845
Due after one year through five years		14,945		15,240
Due after five years through 10 years		2,617		2,708
Due after 10 years		4,337		4,423

Total	$	31,736	$	32,216

NOTE 5 DERIVATIVES

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

Foreign Currency

Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge positions. Options and forward contracts are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash-flow hedging instruments. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. As of December 31, 2009, the total notional amount of such foreign exchange contracts sold was $9.1 billion. Foreign currency risks related to certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are designated as fair-value hedging instruments. As of December 31, 2009, the total notional amount of these foreign exchange contracts sold was $3.7 billion. Certain options and forwards not designated as hedging instruments are also used to manage the variability in exchange rates on accounts receivable, cash, and intercompany positions, and to manage other foreign currency exposures. As of December 31, 2009, the total notional amounts of these foreign exchange contracts purchased and sold were $4.5 billion and $4.6 billion, respectively.

Equity

Securities held in our equity and other investments portfolio are subject to market price risk. Market price risk is managed relative to broad-based global and domestic equity indices using certain convertible preferred investments, options, futures, and swap contracts not designated as hedging instruments. From time to time, to hedge our price risk, we may use and designate equity derivatives as hedging instruments, including puts, calls, swaps, and forwards. As of December 31, 2009, the total notional amounts of designated and non-designated equity contracts purchased and sold were immaterial.

Interest Rate

Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of our fixed-income portfolio to achieve economic returns that correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts and over-the-counter swap and option contracts, none of which are designated as hedging instruments. As of December 31, 2009, the total notional amount of fixed-interest rate contracts purchased and sold were $1.7 billion and $653 million, respectively. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed securities. These meet the definition of a derivative instrument in cases where physical delivery of the assets is not taken at the earliest available delivery date. As of December 31, 2009, the total notional derivative amount of mortgage contracts purchased was $858 million.


PAGE		11

PART I

Item 1

Credit

Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts, not designated as hedging instruments, to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. We use credit default swaps as they are a low cost method of managing exposure to individual credit risks or groups of credit risks. As of December 31, 2009, the total notional amounts of credit contracts purchased and sold were immaterial.

Commodity

We use broad-based commodity exposures to enhance portfolio returns and to facilitate portfolio diversification. We use swap and futures contracts, not designated as hedging instruments, to generate and manage exposures to broad-based commodity indices. We use derivatives on commodities as they are low-cost alternatives to the purchase and storage of a variety of commodities, including, but not limited to, precious metals, energy, and grain. As of December 31, 2009, the total notional amounts of commodity contracts purchased and sold were $692 million and $22 million, respectively.

Credit-Risk-Related Contingent Features

Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured debt to maintain an investment grade credit rating and require us to maintain a minimum liquidity of $1.0 billion. To the extent we fail to meet these requirements, we will be required to post collateral, similar to the standard convention related to over-the-counter derivatives. As of December 31, 2009, our long-term unsecured debt rating was AAA, and cash investments were in excess of $1.0 billion. As a result, no collateral is required to be posted.

Fair Values of Derivative Instruments

Following are the gross fair values of derivative instruments held at December 31, 2009, excluding the impact of netting derivative assets and liabilities when a legally enforceable master netting agreement exists and fair value adjustments related to our own credit risk and counterparty credit risk:


(In millions)	Foreign Exchange Contracts		Equity Contracts		Interest Rate Contracts		Credit Contracts		Commodity Contracts		Total Derivatives


Assets
Derivatives not designated as hedging instruments:
Short-term investments	$	13	$	112	$	5	$	7	$	26	$	163
Other current assets		80		—		—		—		—		80

Total	$	93	$	112	$	5	$	7	$	26	$	243
Derivatives designated as hedging instruments:
Short-term investments	$	87	$	—	$	—	$	—	$	—	$	87
Other current assets		284		—		—		—		—		284

Total	$	371	$	—	$	—	$	—	$	—	$	371

Total assets	$	464	$	112	$	5	$	7	$	26	$	614


PAGE		12

PART I

Item 1


(In millions)	Foreign Exchange Contracts			Equity Contracts			Interest Rate Contracts			Credit Contracts			Commodity Contracts			Total Derivatives


Liabilities
Derivatives not designated as hedging instruments:
Other current liabilities	$	(39	)	$	(5	)	$	(6	)	$	(42	)	$	(9	)	$	(101	)
Derivatives designated as hedging instruments:
Other current liabilities	$	(103	)	$	—		$	—		$	—		$	—		$	(103	)

Total liabilities	$	(142	)	$	(5	)	$	(6	)	$	(42	)	$	(9	)	$	(204	)

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

Fair-Value Hedges

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

We recognized in other income (expense) the following gains (losses) on foreign exchange contracts designated as fair value hedges (our only fair value hedges during the period) and their related hedged items:


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


		2009				2009

Derivatives		$	89			$	(104	)
Hedged items			(85	)			103

Total		$	4			$	(1	)

Cash-Flow Hedges

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

We recognized the following gains (losses) related to foreign exchange contracts designated as cash flow hedges (our only cash flow hedges during the period):


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


		2009			2009

Effective portion
Gain (loss) recognized in OCI, net of tax effect of $1 and $(111)		$	2		$	(207	)
Gain reclassified from accumulated OCI into revenue		$	68		$	237

Amount excluded from effectiveness assessment and ineffective portion
Gain (loss) recognized in other income (expense)		$	26		$	(14	)


PAGE		13

PART I

Item 1

We estimate that $92 million of net derivative gains included in OCI will be reclassified into earnings within the next 12 months. No significant amounts of gains (losses) were reclassified from OCI into earnings as a result of forecasted transactions that failed to occur during the three months and six months ended December 31, 2009.

Non-Designated Derivatives

Gains (losses) from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense). These amounts are shown in the table below, with the exception of gains (losses) on derivatives presented in income statement line items other than other income (expense), which were immaterial for the three months and six months ended December 31, 2009. Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) below are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities, which are recorded as a component of OCI until the securities are sold or other-than-temporarily impaired, at which time the amounts are moved from OCI into other income (expense).


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


		2009			2009

Foreign exchange contracts		$	47		$	90
Equity contracts			7			16
Interest-rate contracts			9			12
Credit contracts			2			11
Commodity contracts			54			69

Total		$	119		$	198

NOTE 6 FAIR VALUE MEASUREMENTS

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

•

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

•

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

•

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


PAGE		14

PART I

Item 1

Assets and Liabilities Measured at Fair Value on a Recurring Basis

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


(In millions)		Level 1		Level 2		Level 3		Gross Fair Value		Netting	⁽¹⁾		Net Fair Value


December 31, 2009

Assets
Mutual funds	$	1,713	$	—	$	—	$	1,713	$	—		$	1,713
Commercial paper		—		2,450		—		2,450		—			2,450
Certificates of deposit		—		3,292		—		3,292		—			3,292
U.S. government and agency securities		9,321		3,246		—		12,567		—			12,567
Foreign government bonds		472		3,050		—		3,522		—			3,522
Mortgage-backed securities		—		4,083		—		4,083		—			4,083
Corporate notes and bonds		—		5,381		192		5,573		—			5,573
Municipal securities		—		538		—		538		—			538
Common and preferred stock		6,233		39		5		6,277		—			6,277
Derivatives		22		588		4		614		(149	)		465

Total	$	17,761	$	22,667	$	201	$	40,629	$	(149	)	$	40,480

Liabilities
Derivatives	$	7	$	197	$	—	$	204	$	(147	)	$	57


(In millions)		Level 1		Level 2		Level 3		Gross Fair Value		Netting	⁽¹⁾		Net Fair Value


June 30, 2009

Assets
Mutual funds	$	982	$	—	$	—	$	982	$	—		$	982
Commercial paper		—		2,601		—		2,601		—			2,601
Certificates of deposit		—		555		—		555		—			555
U.S. government and agency securities		7,134		6,105		—		13,239		—			13,239
Foreign government bonds		501		3,022		—		3,523		—			3,523
Mortgage-backed securities		—		3,593		—		3,593		—			3,593
Corporate notes and bonds		—		4,073		253		4,326		—			4,326
Municipal securities		—		256		—		256		—			256
Common and preferred stock		4,218		28		5		4,251		—			4,251
Derivatives		5		623		5		633		(235	)		398

Total	$	12,840	$	20,856	$	263	$	33,959	$	(235	)	$	33,724

Liabilities
Derivatives	$	5	$	344	$	—	$	349	$	(231	)	$	118

(1)	This table includes the impact of netting derivative assets and derivative liabilities when a legally enforceable master netting agreement exists. These amounts also include fair value adjustments related to our own credit risk and counterparty credit risk.


PAGE		15

PART I

Item 1

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

The following tables present the changes during the three months and six months ended December 31, 2009 and 2008 in our Level 3 financial instruments that are measured at fair value on a recurring basis. The majority of these instruments consist of investment securities classified as available-for-sale with changes in fair value included in other comprehensive income.


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


Three Months and Six Months Ended December 31, 2009

Balance as of June 30, 2009	$	253		$	5		$	5		$	263
Total realized and unrealized gains (losses):
Included in other income (expense)		1			—			(2	)		(1	)
Included in other comprehensive income		(74	)		—			—			(74	)

Balance as of September 30, 2009	$	180		$	5		$	3		$	188
Total realized and unrealized gains:
Included in other income (expense)		1			—			1			2
Included in other comprehensive income		11			—			—			11

Balance as of December 31, 2009	$	192		$	5		$	4		$	201

Change in unrealized gains (losses) included in other income (expense) for the three months ended December 31, 2009 related to assets held as of December 31, 2009	$	1		$	—		$	1		$	2
Change in unrealized gains (losses) included in other income (expense) for the six months ended December 31, 2009 related to assets held as of December 31, 2009	$	2		$	—		$	(1	)	$	1


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


Three Months and Six Months Ended December 31, 2008

Balance as of June 30, 2008	$	138		$	8		$	71		$	217
Total realized and unrealized gains (losses):
Included in other income (expense)		(9	)		(4	)		48			35
Included in other comprehensive income		(29	)		—			—			(29	)
Purchases, issuances, and settlements		—			—			(104	)		(104	)
Transfers in and out of Level 3		11			—			—			11

Balance as of September 30, 2008	$	111		$	4		$	15		$	130
Total realized and unrealized gains (losses):
Included in other income (expense)		1			(2	)		—			(1	)
Included in other comprehensive income		10			—			—			10
Purchases, issuances, and settlements		—			—			(15	)		(15	)
Transfers in and out of Level 3		(1	)		—			—			(1	)

Balance as of December 31, 2008	$	121		$	2		$	—		$	123

Change in unrealized gains (losses) included in other income (expense) for the three months ended December 31, 2008 related to assets held as of December 31, 2008	$	—		$	(2	)	$	—		$	(2	)
Change in unrealized gains (losses) included in other income (expense) for the six months ended December 31, 2008 related to assets held as of December 31, 2008	$	(9	)	$	(5	)	$	1		$	(13	)

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

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


PAGE		16

PART I

Item 1

An impairment charge is recorded when the cost of the investment exceeds its fair value and this condition is determined to be other-than-temporary. During the three months and six months ended December 31, 2009, we did not record any other-than-temporary impairments on those assets required to be measured at fair value on a non-recurring basis. The following table presents prior period balances for those assets required to be measured at fair value on a nonrecurring basis and the associated losses recognized during the three months and six months ended December 31, 2008:

(In millions)

December 31,
2008

Level 1

Level 2

Level 3

Total
Losses

Assets

Common and preferred stock

164

—

164

(85

)

Total

164

—

164

(85

)

NOTE 7 INVENTORIES

The components of inventories were as follows:


(In millions)	December 31,			June 30,


2009				2009

Raw materials		$	100	$	170
Work in process			11		45
Finished goods			478		502

Total		$	589	$	717

NOTE 8 BUSINESS COMBINATIONS

During the six months ended December 31, 2009, we acquired four entities for total consideration of $110 million, substantially all of which was paid in cash. During this period, we also sold three entities for total consideration of $602 million, including Razorfish in the second quarter of fiscal year 2010. These entities have been included in or removed from our consolidated results of operations since their acquisition or sale dates, respectively. Pro forma results of operations have not been presented because the effects of these business combinations, individually and in the aggregate, were not material to our consolidated results of operations.

NOTE 9 GOODWILL

Following are details of the changes in our goodwill balances during the three months and six months ended December 31, 2009:


(In millions)	Balance		Acquisitions		Purchase Accounting Adjustments and Other			Balance


September 30, 2009				December 31, 2009

Windows & Windows Live Division	$	77	$	—	$	—		$	77
Server and Tools		1,070		49		—			1,119
Online Services Division		6,633		—		(261	)		6,372
Microsoft Business Division		3,998		—		(2	)		3,996
Entertainment and Devices Division		804		—		—			804

Total	$	12,582	$	49	$	(263	)	$	12,368


PAGE		17

PART I

Item 1


(In millions)	Balance		Acquisitions		Purchase Accounting Adjustments and Other			Balance


		June 30, 2009		December 31, 2009

Windows & Windows Live Division	$	77	$	—	$	—		$	77
Server and Tools		1,038		82		(1	)		1,119
Online Services Division		6,657		—		(285	)		6,372
Microsoft Business Division		3,927		3		66			3,996
Entertainment and Devices Division		804		—		—			804

Total	$	12,503	$	85	$	(220	)	$	12,368

None of the amounts recorded as goodwill are expected to be deductible for tax purposes. The measurement period for purchase price allocations ends as soon as information on the facts and circumstances becomes available, but will not exceed 12 months. Adjustments in the purchase price allocation may require a recasting of the amounts allocated to goodwill retroactive to the period in which the acquisition occurred. Any change in the goodwill amounts resulting from foreign currency translations are presented as “other” in the table above. Also included within “other” is $263 million for the three months ended December 31, 2009 and $286 million for the six months ended December 31, 2009 of goodwill associated with business dispositions. See also Note 8.

In connection with the disposal of Razorfish, we performed an interim impairment analysis of our Online Services Division goodwill balance during the first quarter of fiscal year 2010. No impairment of goodwill was identified.

NOTE 10 INTANGIBLE ASSETS

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


(In millions)	Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount		Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount


		December 31, 2009							June 30, 2009

Contract-based	$	1,087	$	(884	)	$	203	$	1,087	$	(855	)	$	232
Technology-based		2,158		(1,284	)		874		2,033		(1,090	)		943
Marketing-related		117		(78	)		39		188		(97	)		91
Customer-related		445		(215	)		230		732		(239	)		493

Total	$	3,807	$	(2,461	)	$	1,346	$	4,040	$	(2,281	)	$	1,759

We generally amortize acquired intangibles on a straight-line basis over their estimated weighted average lives. Intangible assets amortization expense was $169 million for the three months and $318 million for the six months ended December 31, 2009 as compared with $145 million for the three months and $285 million for the six months ended December 31, 2008. The following table outlines the estimated future amortization expense related to intangible assets held at December 31, 2009:


(In millions)


Year Ending June 30,

2010 (excluding the six months ended December 31, 2009)	$	264
2011		509
2012		346
2013		205
2014 and thereafter		22

Total	$	1,346


PAGE		18

PART I

Item 1

NOTE 11 DEBT

In September 2008, our Board of Directors authorized debt financings of up to $6.0 billion. Our initial commercial paper program provided for the issuance and sale of up to $2.0 billion. Following the issuance of our long-term debt in May 2009, we increased the commercial paper program and issued an additional $250 million of commercial paper during the six months ended December 31, 2009. As of December 31, 2009, we had $2.25 billion of commercial paper and $3.75 billion of long-term debt issued and outstanding.

Short-term Debt

In November 2009, we replaced our $2.0 billion and $1.0 billion credit facilities with a $2.25 billion 364-day credit facility, which expires on November 5, 2010. This facility serves as a back-up for our commercial paper program. As of December 31, 2009, we were in compliance with the financial covenant in the credit facility, which requires a coverage ratio be maintained of at least three times earnings before interest, taxes, depreciation, and amortization to interest expense. No amounts were drawn against the credit facilities during the six months ended December 31, 2009.

Long-term Debt

As of December 31, 2009, we had issued and outstanding $3.75 billion of debt securities as follows: $2.0 billion aggregate principal amount of 2.95% notes due 2014, $1.0 billion aggregate principal amount of 4.20% notes due 2019, and $750 million aggregate principal amount of 5.20% notes due 2039 (collectively “the Notes”). Interest on the Notes is payable semi-annually on June 1 and December 1 of each year to holders of record on the preceding May 15 and November 15. The Notes are senior unsecured obligations and rank equally with our other unsecured and unsubordinated debt outstanding.

As of December 31, 2009, the total carrying value and estimated fair value of our long-term debt were $3.75 billion and $3.77 billion, respectively. The estimated fair value is based on quoted prices for our publicly-traded debt as of December 31, 2009.

NOTE 12 INCOME TAXES

Our effective tax rate was 25% for both the three months and six months ended December 31, 2009, as compared with 26% for the three months and 27% for the six months ended December 31, 2008. The fiscal year 2010 rate reflects a higher mix of foreign earnings taxed at lower rates.

Tax contingencies and other tax liabilities were $6.1 billion as of December 31, 2009 and $5.5 billion as of June 30, 2009, and were included in other long-term liabilities.

NOTE 13 UNEARNED REVENUE

The components of unearned revenue were as follows:


(In millions)	December 31,			June 30,


			2009		2009

Volume licensing programs		$	10,058	$	11,350
Undelivered elements			600		1,083
Other			1,870		1,851

Total		$	12,528	$	14,284


PAGE		19

PART I

Item 1

Unearned revenue by segment was as follows:


(In millions)	December 31,			June 30,


2009				2009

Windows & Windows Live Division		$	1,736	$	2,345
Server and Tools			4,227		4,732
Microsoft Business Division			5,680		6,508
Other segments			885		699

Total		$	12,528	$	14,284

NOTE 14 PRODUCT WARRANTIES

We provide for the estimated costs of hardware and software warranties at the time the related revenue is recognized. For hardware warranties, we estimate the costs based on historical and projected product failure rates, historical and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and country in which we do business, but generally include parts and labor over a period generally ranging from 90 days to three years. For software warranties, we estimate the costs to provide bug fixes, such as security patches, over the estimated life of the software. We regularly re-evaluate our estimates to assess the adequacy of the recorded warranty liabilities and adjust the amounts as necessary.

Our aggregate product warranty liabilities, which are included in other current liabilities and other long-term liabilities on our balance sheets, changed during the three months and six months ended December 31, 2009 as follows:


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


		2009				2009

Balance, beginning of period		$	289			$	342
Accrual for warranties issued			61				94
Adjustments to pre-existing warranties			(2	)			(2	)
Settlements of warranty claims			(40	)			(126	)

Balance, end of period		$	308			$	308

NOTE 15 CONTINGENCIES

Government Competition Law Matters

In March 2004, the European Commission issued a competition law decision that, among other things, ordered us to license certain Windows server protocol technology to our competitors. In March 2007, the European Commission issued a statement of objections claiming that the pricing terms we proposed for licensing the technology as required by the March 2004 decision were “not reasonable.” Following additional steps we took to address these concerns, the Commission announced on October 22, 2007 that we were in compliance with the March 2004 decision and that no further penalty should accrue after that date. On February 27, 2008, the Commission issued a fine of $1.4 billion (€899 million) relating to the period prior to October 22, 2007. In May 2008, we filed an application with the European Court of First Instance to annul the February 2008 fine. We paid the $1.4 billion (€899 million) fine in June 2008, pending the outcome of the appeal.

On December 16, 2009, the European Commission announced that it had adopted a decision that renders legally binding commitments offered by Microsoft to address the Commission’s concerns regarding competition in Web browsing software. This decision ends the Commission’s investigation. It does not address whether a violation of European Commission competition law occurred. The commitments offered by Microsoft broadly ensure that computer manufacturers will remain free to install any browser on the PCs they ship, and they provide for a Web browser “choice screen” to be offered to end users throughout Europe. The Commission had opened its investigation in January 2008 following a complaint filed with the Commission by Opera Software ASA.


PAGE		20

PART I

Item 1

In January 2008, the Commission also opened a competition law investigation that relates primarily to interoperability with respect to our Microsoft Office family of products. This investigation resulted from complaints filed with the Commission by a trade association of Microsoft’s competitors. Microsoft has made a number of proposals to address the Commission’s competition law concerns in this area. The Commission announced on December 16, 2009 that it welcomed these proposals and that it will take them into account in assessing this matter.

We are also subject to a Consent Decree and Final Judgment (“Final Judgments”) that resolved lawsuits brought by the U.S. Department of Justice, 18 states, and the District of Columbia in two separate actions. The Final Judgments imposed various constraints on our Windows operating system businesses. The Final Judgments are scheduled to expire in May 2011.

In other ongoing investigations, various foreign governments and several state attorneys general have requested information from us concerning competition, privacy, and security issues.

Antitrust, Unfair Competition, and Overcharge Class Actions

A large number of antitrust and unfair competition class action lawsuits were filed against us in various state, federal, and Canadian courts on behalf of various classes of direct and indirect purchasers of our PC operating system and certain other software products. We obtained dismissals of damages claims of indirect purchasers under federal law and in 15 states. Courts refused to certify classes in two additional states. We have reached agreements to settle all claims that have been made to date in 19 states and the District of Columbia.

Under the settlements, generally class members can obtain vouchers that entitle them to be reimbursed for purchases of a wide variety of platform-neutral computer hardware and software. The total value of vouchers that we may issue varies by state. We will make available to certain schools a percentage of those vouchers that are not issued or claimed (one-half to two-thirds depending on the state). The total value of vouchers we ultimately issue will depend on the number of class members who make claims and are issued vouchers. The maximum value of vouchers to be issued is approximately $2.7 billion. The actual costs of these settlements will be less than that maximum amount, depending on the number of class members and schools that are issued and redeem vouchers.

The settlements in all states have received final court approval. Cases in Canada have not been settled. We estimate the total cost to resolve all of the overcharge class action cases will range between $1.8 billion and $2.0 billion. The actual cost depends on factors such as the claim rate, the quantity and mix of products for which claims are made, the number of eligible class members who ultimately use the vouchers, the nature of hardware and software that is acquired using the vouchers, and the cost of administering the claims. At December 31, 2009, we have recorded a liability related to these claims of approximately $700 million, which reflects our estimated exposure of $1.8 billion less payments made to date of approximately $1.1 billion mostly for vouchers, legal fees, and administrative expenses.

Other Antitrust Litigation and Claims

In November 2004, Novell, Inc. filed a complaint in U.S. District Court for the District of Utah, asserting antitrust and unfair competition claims against us related to Novell’s ownership of WordPerfect and other productivity applications during the period between June 1994 and March 1996. This case was transferred to the District of Maryland. In June 2005, the trial court granted our motion to dismiss four of six claims of the complaint. Both parties appealed, and in October 2007, the court of appeals affirmed the decision of the trial court, and remanded the case to that court for further proceedings. Summary judgment motions were filed in October 2009, and will be heard in March 2010. If any claims survive those motions, the case will be transferred back to Utah for trial.

Patent and Intellectual Property Claims

In 2003, we filed an action in U.S. District Court in California seeking a declaratory judgment that we do not infringe certain Alcatel-Lucent patents (although this action began before the merger of Alcatel and Lucent in 2006, for simplicity we refer to the post-merger entity of Alcatel-Lucent). In April 2008, a jury returned a verdict in Alcatel-Lucent’s favor in a trial on a consolidated group of one video and three user interface patents. The jury concluded that we had infringed two user interface patents and awarded $367 million in damages. In June 2008, the trial judge increased the amount of damages to $512 million to include $145 million of interest. We appealed that award to the Federal Circuit. In December 2008, we entered into a settlement agreement resolving all other litigation pending between Microsoft and Alcatel-Lucent, leaving approximately $500 million remaining in dispute. In April 2009, the


PAGE		21

PART I

Item 1

U.S. Patent and Trademark Office, after a reexamination of the remaining patent in dispute, determined that the patent was invalid and Alcatel-Lucent has appealed that ruling. On September 11, 2009, the United States Court of Appeals for the Federal Circuit affirmed the liability award but vacated the verdict and remanded the case to the trial court for a re-trial of the damages ruling, indicating the damages previously awarded were too high.

In October 2003, Uniloc USA Inc., a subsidiary of a Singapore-based security technology company, filed a patent infringement suit in U.S. District Court in Rhode Island, claiming that product activation technology in Windows XP and certain other Microsoft programs violated a Uniloc patent. After we obtained a favorable summary judgment that we did not infringe any of the claims of this patent, the court of appeals vacated the trial court decision and remanded the case for trial. In April 2009, the jury returned a $388 million verdict against us, including a finding of willful infringement. On September 29, 2009, the district court judge overturned the jury verdict, ruling that the evidence did not support the jury’s finding that Microsoft infringed the patent. Uniloc has appealed.

In March 2007, i4i Limited Partnership sued Microsoft in U.S. District Court in Texas claiming that certain custom XML technology in Word 2003 and 2007 infringed i4i’s patent. In May 2009, a jury returned a verdict against us, finding damages of $200 million and that we willfully infringed the patent. In August 2009, the court denied our post-trial motions and awarded enhanced damages of $40 million and prejudgment interest of $37 million. The court also issued a permanent injunction prohibiting additional distribution of the allegedly infringing technology. We appealed and the appellate court stayed the injunction pending our appeal. On December 22, 2009, the court of appeals rejected our appeal and affirmed the trial court’s judgment and injunction, except that the court of appeals modified the effective date of the injunction to January 11, 2010. We are seeking a rehearing before the court of appeals.

There are over 50 other patent infringement cases pending against Microsoft, 10 of which are set for trial in fiscal year 2010. These cases include a lawsuit filed against Microsoft by VirnetX Inc. in U.S. District Court in Texas in which VirnetX asserts that various Microsoft products including Windows client and server operating systems software and communications software infringe patents relating to certain secure Internet communications. Trial is scheduled for March 2010.

Other

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

As of December 31, 2009, we had accrued aggregate liabilities of approximately $900 million in other current liabilities and approximately $400 million in other long-term liabilities for all of the contingent matters described in this note. While we intend to vigorously defend these matters, there exists the possibility of adverse outcomes that we estimate could be up to $1.0 billion in aggregate beyond recorded amounts. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact on our financial statements for the period in which the effects become reasonably estimable.

NOTE 16 EMPLOYEE SEVERANCE

In January 2009, we announced and implemented a resource management program to reduce discretionary operating expenses, employee headcount, and capital expenditures. As part of this program, we announced the elimination of 5,000 positions in research and development, marketing, sales, finance, legal, human resources, and information technology by June 30, 2010. As of September 30, 2009, we had reduced our overall number of positions by approximately 5,000 and headcount by approximately 4,600.

In November 2009, we identified an additional 800 positions for elimination based on our efforts to manage our expenses. Severance expense of approximately $52 million associated with these additional eliminations was reflected in our second quarter financial statements. To date, we have had a headcount reduction of approximately 5,300 under our resource management efforts.


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Item 1

The changes in our employee severance liabilities related to our resource management efforts during the three months and six months ended December 31, 2009 were as follows:


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


	2009				2009

Balance, beginning of period		$	42			$	127
Additional accruals			52				52
Adjustments			7				7
Cash payments			(70	)			(155	)

Balance, end of period		$	31			$	31

NOTE 17 STOCKHOLDERS’ EQUITY

Share Repurchases

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

(In millions)

Three Months Ended

December 31,

Six Months Ended

December 31,

2009

2008

2009

2008

Shares of common stock repurchased

125

183

318

Value of common stock repurchased

3,583

2,234

5,028

8,200

We repurchased all shares with cash resources. As of December 31, 2009, approximately $29.5 billion remained of our $40.0 billion repurchase program that we announced on September 22, 2008. The repurchase program expires September 30, 2013 but may be suspended or discontinued at any time without notice.

Dividends

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


Declaration Date	Per Share Dividend		Record Date	Total Amount		Payment Date

				(in millions)
Fiscal year 2010
September 18, 2009	$	0.13	November 19, 2009	$	1,152	December 10, 2009
December 9, 2009	$	0.13	February 18, 2010	$	1,145	March 11, 2010

Fiscal year 2009
September 19, 2008	$	0.13	November 20, 2008	$	1,157	December 11, 2008
December 10, 2008	$	0.13	February 19, 2009	$	1,155	March 12, 2009

The estimate of the amount to be paid as a result of the December 9, 2009 declaration was included in other current liabilities as of December 31, 2009.

NOTE 18 SEGMENT INFORMATION

In its operation of the business, management reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. Our five segments are: Windows & Windows Live Division; Server and Tools; Online Services Division; Microsoft Business Division; and Entertainment and Devices Division. We have recast certain prior period amounts within this note to conform to the way we internally managed and monitored segment performance during the current fiscal year, including moving Windows Live from Online Services Division to Windows & Windows Live Division, Mobile Services from Online Services Division to Entertainment and Devices Division, and Razorfish from Online Services Division to Corporate. Razorfish was disposed of during the second quarter of fiscal year 2010.


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PART I

Item 1

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


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


	2009			2008			2009			2008

Revenue
Windows & Windows Live Division	$	5,073		$	3,930		$	9,058		$	8,041
Server and Tools		3,848			3,775			7,285			7,214
Online Services Division		581			595			1,067			1,108
Microsoft Business Division		4,749			4,893			9,155			9,810
Entertainment and Devices Division		2,938			3,256			4,829			5,149
Unallocated and other		1,833			180			548			368

Consolidated	$	19,022		$	16,629		$	31,942		$	31,690

Operating income (loss)
Windows & Windows Live Division	$	3,516		$	2,550		$	6,324		$	5,409
Server and Tools		1,370			1,336			2,606			2,336
Online Services Division		(478	)		(378	)		(972	)		(704	)
Microsoft Business Division		2,914			2,991			5,747			6,096
Entertainment and Devices Division		361			103			654			237
Reconciling amounts		830			(663	)		(1,364	)		(1,436	)

Consolidated	$	8,513		$	5,939		$	12,995		$	11,938

Because of our integrated business structure, operating costs included in one segment may benefit other segments, and therefore these segments are not designed to measure operating income or loss directly related to the products included in each segment. Inter-segment cost commissions are estimated by management and used to compensate or charge each segment for such shared costs and to incent shared efforts. Management will continually evaluate the alignment of product development organizations, sales organizations, and inter-segment commissions for segment reporting purposes, which may result in changes to segment allocations in future periods.

Assets are not allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment and it is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss.

Reconciling amounts include adjustments to conform with U.S. GAAP and corporate-level activity not specifically attributed to a segment. Significant internal accounting policies that differ from U.S. GAAP relate to revenue recognition, income statement classification, and accelerated depreciation and amortization of stock-based awards. In addition, certain revenue and expenses are excluded from segments or included in corporate-level activity, including certain legal settlements, accruals for legal contingencies, and accruals for employee severance. For the three months ended December 31, 2009, reconciling amounts include the recognition of previously deferred revenue related to sales of Windows Vista with a guarantee to be upgraded to Windows 7 at minimal or no cost and sales of Windows 7 to original equipment manufacturers and retailers before general availability.


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PART I

Item 1

Significant reconciling items were as follows:


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


	2009			2008			2009			2008

Corporate-level activity ⁽¹⁾	$	(1,291	)	$	(979	)	$	(2,229	)	$	(2,086	)
Stock-based compensation		109			191			229			371
Revenue reconciling amounts		1,787			116			421			303
Other		225			9			215			(24	)

Total	$	830		$	(663	)	$	(1,364	)	$	(1,436	)

(1)	Corporate-level activity excludes stock-based compensation and revenue reconciling amounts presented separately in those line items.


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PART I

Item 1

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of Microsoft Corporation

Redmond, Washington

We have reviewed the accompanying consolidated balance sheet of Microsoft Corporation and subsidiaries (the “Corporation”) as of December 31, 2009, and the related consolidated statements of income, stockholders’ equity, and cash flows for the three-month and six-month periods ended December 31, 2009 and 2008. These interim financial statements are the responsibility of the Corporation’s management.

We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to such consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Microsoft Corporation and subsidiaries as of June 30, 2009, and the related consolidated statements of income, stockholders’ equity, and cash flows for the year then ended (not presented herein); and in our report dated July 29, 2009 we expressed an unqualified opinion on those consolidated financial statements (which report includes an explanatory paragraph regarding the adoption of new accounting standards). In our opinion, the information set forth in the accompanying consolidated balance sheet as of June 30, 2009 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/S/ DELOITTE & TOUCHE LLP

Seattle, Washington

January 28, 2010


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PART I

Item 2

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Note About Forward-Looking Statements

Certain statements in Management’s Discussion and Analysis (“MD&A”), 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. These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “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” (refer to Part II, Item 1A). We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events, or otherwise.

OVERVIEW

Management’s discussion and analysis is intended to help the reader understand the results of operations and financial condition of Microsoft Corporation. The following discussion should be read in conjunction with our Annual Report on Form 10-K for the year ended June 30, 2009 and the Consolidated Financial Statements and accompanying notes (“Notes”) included in this Form 10-Q.

We generate revenue by developing, manufacturing, licensing, and supporting a wide range of software products and services for many different types of computing devices. Our software products and services include operating systems for personal computers, servers, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutions applications; high-performance computing applications; software development tools; and video games. We provide consulting and product and solution support services, and we train and certify computer system integrators and developers. We also design and sell hardware, including the Xbox 360 video game console, the Zune digital music and entertainment device, and peripherals. Online offerings and information are delivered through Bing, Windows Live, Office Live, Xbox LIVE, our MSN portals and channels, and the Microsoft Online Services platform, which includes offerings for businesses, such as Microsoft Dynamics CRM Online, Exchange Hosted Services, Exchange Online, and SharePoint Online. We enable the delivery of online advertising across our broad range of digital media properties and on Bing through our proprietary adCenter platform.

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 revenues in our second fiscal quarter. In addition, quarterly revenues may be impacted by the deferral of revenue. See the discussion below regarding the deferral of revenue related to Windows 7, which negatively impacted revenue for the first quarter of fiscal year 2010 and positively impacted revenue for the second quarter of fiscal year 2010.

All growth and percentage comparisons refer to the three months and six months ended December 31, 2009, as compared with the three months and six months ended December 31, 2008, unless otherwise noted.

Summary


(In millions, except per share amounts and percentages)	Three Months Ended December 31,				Percentage Change	Six Months Ended December 31,				Percentage Change


	2009		2008			2009		2008

Revenue	$	19,022	$	16,629	14%	$	31,942	$	31,690	1%
Operating income	$	8,513	$	5,939	43%	$	12,995	$	11,938	9%
Diluted earnings per share	$	0.74	$	0.47	57%	$	1.14	$	0.94	21%


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PART I

Item 2

Three months ended December 31, 2009 compared with three months ended December 31, 2008

Revenue increased mainly due to the launch of Windows 7 on October 22, 2009. Operating income increased reflecting increased revenue and decreased operating expenses in most categories.

•

Cost of revenue decreased $279 million or 7%, primarily reflecting decreased Xbox 360 console costs and cost controls, offset in part by increased online costs, mainly traffic acquisition costs.

•

Research and development expenses decreased $211 million or 9%, primarily reflecting a decrease in third-party development and programming costs, a decrease in headcount, and the capitalization of certain software development costs.

•

General and administrative expenses increased $293 million or 35%, primarily due to increased legal charges.

Diluted earnings per share increased primarily reflecting increased net income and share repurchases during the past 12 months. We repurchased 183 million shares during the 12 months ended December 31, 2009.

Six months ended December 31, 2009 compared with six months ended December 31, 2008

Revenue increased mainly due to the launch of Windows 7 on October 22, 2009. Operating income increased reflecting increased revenue and decreased operating expenses in most categories.

•

Research and development expenses decreased $429 million or 9%, primarily reflecting a decrease in third-party development and programming costs, a decrease in headcount, and the capitalization of certain software development costs.

•

Sales and marketing expenses decreased $297 million or 4%, due mainly to cost controls and decreased corporate marketing and advertising spending.

•

Cost of revenue decreased $285 million or 4%, primarily reflecting decreased Xbox 360 console costs and cost controls, offset in part by increased online costs, mainly traffic acquisition costs.

•

General and administrative expenses increased $147 million or 9%, primarily due to increased legal charges, offset in part by cost controls.

Diluted earnings per share increased primarily reflecting increased net income and share repurchases during the past 12 months.

Demand for our software, services, hardware, and online offerings has a strong correlation to global macroeconomic factors. While we see the potential for improvement in calendar year 2010, the timing is uncertain. In the meantime, we are positive about our relative market position and our product delivery plans. In addition, we remain focused on executing in the areas we can control by continuing to provide high value products at the lowest total cost of ownership while managing our expenses.

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 United States of America (“U.S. GAAP”) and include certain reconciling items attributable to each of the segments. Segment information appearing in Note 18 – Segment Information of the Notes to Financial Statements (Part I, Item I) 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 section to conform to the way we internally managed and monitored segment performance during fiscal year 2010, including moving Windows Live from Online Services Division to Windows & Windows Live Division, Mobile Services from Online Services Division to Entertainment and Devices Division, and Razorfish from Online Services Division to Corporate. Razorfish was disposed of in the second quarter of fiscal year 2010.


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Item 2

Windows & Windows Live Division


(In millions, except percentages)	Three Months Ended December 31,				Percentage Change	Six Months Ended December 31,				Percentage Change


	2009		2008			2009		2008

Revenue	$	6,904	$	4,064	70%	$	9,528	$	8,337	14%
Operating income	$	5,394	$	2,712	99%	$	6,854	$	5,761	19%

Windows & Windows Live (“Windows”) Division offerings consist of premium and standard edition Windows operating systems and online software and services through Windows Live. Premium Windows operating systems are those that include additional functionality and are sold at a price above our standard editions. Premium editions include Windows 7 Home Premium, Windows 7 Professional, Windows 7 Ultimate, Windows 7 Enterprise, Windows Vista Business, Windows Vista Home Premium, Windows Vista Ultimate, and Windows Vista Enterprise. Standard editions include Windows 7 Starter, Windows 7 Home Basic, Windows Vista Home Basic, and Windows XP Home. Windows Live primarily generates revenue from online advertising.

Windows Division revenue growth is directly impacted by growth of PC purchases from original equipment manufacturers (“OEMs”) that pre-install versions of Windows operating systems because the OEM channel accounts for approximately 80% of total Windows Division revenue. The remaining approximately 20% of Windows Division revenue (“other revenue”) is generated by commercial and retail sales of Windows and online advertising from Windows Live. In the first quarter of fiscal year 2010, we deferred revenue (the “Windows 7 Deferral”) associated with sales of Windows Vista with a guarantee to be upgraded to Windows 7 at minimal or no cost and with sales of Windows 7 to retailers before general availability. We recognized the majority of this deferred revenue in the second quarter after launching Windows 7 on October 22, 2009.

Three months ended December 31, 2009 compared with three months ended December 31, 2008

Windows Division revenue increased due to strong sales of Windows 7 and PC market improvement. We estimate total worldwide PC shipments from all sources grew approximately 15% to 17%. OEM revenue increased $2.3 billion or 72%. Excluding $1.7 billion of revenue recognized related to the Windows 7 Deferral, OEM revenue increased $664 million or 21%, while OEM license units increased 22%. The OEM revenue increase was primarily driven by PC market growth, higher Windows attach rates across all regions, channels, and types of PCs and the restoration of normal OEM inventory levels, offset in part by PC market changes, including stronger growth of consumer PCs versus business PCs and of emerging markets versus developed markets. Other revenue increased $511 million or 60% driven primarily by strong Windows 7 retail sales.

Windows Division operating income increased as a result of increased revenue, offset in part by increased operating expenses. Cost of revenue increased $81 million or 25%, primarily driven by increased retail product costs, traffic acquisition costs and royalties. Sales and marketing expenses increased $113 million or 18% reflecting increased advertising and marketing campaigns for the launch of Windows 7.

Six months ended December 31, 2009 compared with six months ended December 31, 2008

Windows Division revenue increased primarily as a result of strong sales of Windows 7 and PC market improvement. We estimate total worldwide PC shipments from all sources grew approximately 8% to 10%. OEM revenue increased $708 million or 11%. Excluding the recognition of $248 million of revenue associated with the Windows 7 Deferral, OEM revenue increased $460 million or 7%, while OEM license units increased 14%. The OEM revenue increase was primarily driven by PC market growth, higher Windows attach rates across all regions, channels, and types of PCs and the restoration of normal OEM inventory levels, offset in part by PC market changes, including stronger growth of consumer PCs versus business PCs and of emerging markets versus developed markets. Other revenue increased $483 million or 29% driven primarily by strong Windows 7 retail sales.


PAGE		29

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Item 2

Windows Division operating income increased as a result of increased revenue, offset in part by increased operating expenses. Cost of revenue increased $122 million or 19%, primarily driven by increased retail product costs, traffic acquisition costs, and royalties. Research and development expenses decreased $76 million or 11%, primarily as a result of capitalization of certain software development costs and completion of Windows 7 product development. Sales and marketing expenses increased $74 million or 6%.

Server and Tools


(In millions, except percentages)	Three Months Ended December 31,				Percentage Change	Six Months Ended December 31,				Percentage Change


	2009		2008			2009		2008

Revenue	$	3,844	$	3,755	2%	$	7,278	$	7,172	1%
Operating income	$	1,491	$	1,375	8%	$	2,767	$	2,409	15%

Server and Tools licenses products, applications, tools, content, and services that are designed to make information technology professionals and developers more productive and efficient. Server and Tools product offerings consist of server software licenses and client access licenses (“CAL”) for Windows Server, Microsoft SQL Server, and other server products. We also offer developer tools, training and certification. Our services offerings include Premier product support services and Microsoft Consulting Services. Server products can be run on-site, in a partner-hosted environment, or in a Microsoft-hosted environment. We use multiple channels for licensing, including pre-installed OEM versions, licenses through partners, and licenses directly to end customers. Approximately 50% of Server and Tools revenue comes from annuity volume licensing agreements, approximately 30% is purchased through transactional volume licensing programs, fully packaged product and licenses sold to OEMs, and the remainder comes from services.

Three months ended December 31, 2009 compared with three months ended December 31, 2008

Server and Tools revenue increased reflecting growth in product revenue, offset in part by a decline in services revenue. Product revenue increased $103 million or 3%, primarily driven by growth in Windows Server, Enterprise CAL Suites and System Center revenue. The growth in product revenue reflects continued adoption of Windows platform applications. Services revenue declined $14 million or 2%, primarily due to decreased revenue from consulting services.

Server and Tools operating income increased primarily due to product revenue growth and a decrease in research and development expenses. Research and development expenses decreased $41 million or 7%, primarily driven by decreased headcount-related expenses and third-party development and programming costs.

Six months ended December 31, 2009 compared with six months ended December 31, 2008

Server and Tools revenue increased reflecting growth in product revenue, offset in part by a decline in services revenue. Product revenue increased $138 million or 2%, primarily driven by growth in Enterprise CAL Suites, System Center and SQL Server revenue. The growth in product revenue reflects increased revenue from annuity volume licensing agreements and continued adoption of Windows platform applications. Services revenue declined $32 million or 2%, primarily due to decreased revenue from consulting services.

Server and Tools operating income increased primarily due to product revenue growth and decreases in all operating expense categories. Sales and marketing expenses decreased $87 million or 4%, primarily due to a decrease in headcount-related expenses and corporate marketing expenses. Research and development expenses decreased $70 million or 6%, primarily driven by reduced third-party development and programming costs and headcount-related expenses. Cost of revenue decreased $66 million or 5%, reflecting the decline in demand for consulting services. General and administrative expenses decreased $27 million or 14%, due to decreased headcount-related expenses.


PAGE		30

PART I

Item 2

Online Services Division


(In millions, except percentages)	Three Months Ended December 31,						Percentage Change	Six Months Ended December 31,						Percentage Change


	2009			2008				2009			2008

Revenue	$	581		$	609		(5)%	$	1,067		$	1,132		(6)%
Operating loss	$	(466	)	$	(320	)	(46)%	$	(950	)	$	(635	)	(50)%

Online Services Division (“OSD”) consists of an online advertising platform with offerings for both publishers and advertisers, online information offerings, such as Bing, and the MSN portals and channels around the world. We earn revenue primarily from online advertising, including search, display, and advertiser and publisher tools. Revenue is also generated through subscriptions and transactions generated from online paid services and from MSN narrowband Internet access subscribers (“Access”).

Three months ended December 31, 2009 compared with three months ended December 31, 2008

OSD revenue decreased as a result of lower Access and online advertising revenue. Access revenue decreased $14 million or 29%, reflecting continued migration of subscribers to broadband or other competitively-priced service providers. Online advertising revenue decreased $11 million or 2%, to $516 million, reflecting a decrease in display advertising and advertiser and publisher tools revenue, offset in part by an increase in search revenue. Foreign currency exchange rates accounted for a $13 million or two percentage point increase in revenue.

OSD operating loss increased mainly due to increased cost of revenue and decreased revenue, offset in part by decreased research and development expenses. Cost of revenue increased $171 million or 50%, primarily driven by higher online traffic acquisition costs. Research and development expenses decreased $49 million or 17%, primarily due to decreased third-party development and programming costs and headcount-related expenses.

Six months ended December 31, 2009 compared with six months ended December 31, 2008

OSD revenue decreased primarily as a result of lower online advertising and Access revenue. Online advertising revenue decreased $32 million or 3%, to $934 million, primarily reflecting a decrease in display advertising and advertiser and publisher tools revenue. Access revenue decreased $28 million or 29%, reflecting continued migration of subscribers to broadband or other competitively-priced service providers.

OSD operating loss increased mainly due to increased cost of revenue and decreased revenue, offset in part by decreased research and development expenses. Cost of revenue increased $347 million or 54%, primarily driven by higher online traffic acquisition costs. Research and development expenses decreased $88 million or 16%, primarily due to decreased third-party development and programming costs.

Yahoo! Commercial Agreement

On December 4, 2009, we entered into a definitive 10-year agreement with Yahoo! Inc. (“Yahoo”) whereby Microsoft will provide the exclusive algorithmic and paid search platform for Yahoo websites. We believe this agreement will allow us over time to improve the effectiveness and increase the value of our search offering through greater scale in search queries and an expanded and more competitive search and advertising marketplace. The transaction is subject to regulatory review; we expect to close the transaction in fiscal year 2010.

Microsoft Business Division


(In millions, except percentages)	Three Months Ended December 31,				Percentage Change	Six Months Ended December 31,				Percentage Change


	2009		2008			2009		2008

Revenue	$	4,745	$	4,881	(3)%	$	9,149	$	9,835	(7)%
Operating income	$	3,010	$	3,021	—%	$	5,867	$	6,199	(5)%


PAGE		31

PART I

Item 2

Microsoft Business Division (“MBD”) offerings consist of the Microsoft Office system and Microsoft Dynamics business solutions. Microsoft Office system products are designed to increase personal, team, and organization productivity through a range of programs, services, and software solutions. Microsoft Office system offerings generate over 90% of MBD revenue. Microsoft Dynamics products provide business solutions for financial management, customer relationship management, supply chain management, and analytics applications for small and mid-size businesses, large organizations, and divisions of global enterprises. We evaluate our 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, 2009 compared with three months ended December 31, 2008

MBD revenue decreased reflecting decreased business revenue partially offset by increased consumer revenue. Business revenue decreased $231 million or 6%, primarily reflecting a decline in licensing the 2007 Microsoft Office system to transactional business customers, offset in part by a 1% increase in Microsoft Dynamics revenue. Consumer revenue increased $95 million or 12%, primarily as a result of growth in the PC market.

MBD operating income was flat reflecting decreased revenue, offset by decreased sales and marketing and research and development expenses. Sales and marketing expenses decreased $81 million or 7%, primarily driven by a decrease in corporate marketing activities and headcount-related costs associated with our corporate sales force. Research and development expenses decreased $64 million or 15%, primarily as a result of capitalization of certain Microsoft Office system software development costs.

Six months ended December 31, 2009 compared with six months ended December 31, 2008

MBD revenue decreased reflecting decreased business and consumer revenue. Business revenue decreased $392 million or 5%, primarily reflecting a decline in licensing the 2007 Microsoft Office system to transactional business customers and a 2% decrease in Microsoft Dynamics revenue, offset in part by growth in multi-year volume licensing agreement revenue. The growth in multi-year volume licensing agreement revenue primarily reflects recognition of deferred revenue from previously signed agreements. Consumer revenue decreased $295 million or 15%, primarily as a result of pricing promotions in the first half of fiscal year 2009 that drove increased licensing in that period, a shift to lower-priced products, and a decline in licensing the 2007 Microsoft Office system.

MBD operating income decreased due mainly to decreased revenue, offset in part by decreased sales and marketing and research and development expenses. Sales and marketing expenses decreased $262 million or 12%, primarily driven by a decrease in corporate marketing activities and headcount-related costs associated with our corporate sales force. Research and development expenses decreased $95 million or 11%, primarily as a result of capitalization of certain Microsoft Office system software development costs and lower headcount-related expenses.

Entertainment and Devices Division


(In millions, except percentages)	Three Months Ended December 31,				Percentage Change	Six Months Ended December 31,				Percentage Change


	2009		2008			2009		2008

Revenue	$	2,902	$	3,256	(11)%	$	4,793	$	5,149	(7)%
Operating income	$	375	$	130	188 %	$	686	$	290	137 %

Entertainment and Devices Division (“EDD”) offerings include the Xbox 360 platform (which includes the Microsoft Xbox 360 video game console system, Xbox 360 video games, Xbox LIVE, and Xbox 360 accessories), the Zune digital music and entertainment platform (including Zune HD, which was released in September 2009), PC software games, online games and services, Mediaroom (our Internet protocol television software), the Microsoft Surface computing platform, Windows Mobile and embedded device platforms, and other devices. EDD leads the development efforts for our line of consumer software and hardware products including application software for Apple’s Macintosh computers and Microsoft PC hardware products, and is responsible for all retail sales and marketing for Microsoft Office and Windows operating systems.


PAGE		32

PART I

Item 2

Three months ended December 31, 2009 compared with three months ended December 31, 2008

EDD revenue decreased reflecting a $295 million or 12% decline in Xbox 360 platform and PC game revenue. This decrease was due mainly to decreased revenue from Xbox 360 video games, decreased Xbox 360 consoles sold, and decreased revenue per console, offset in part by increased Xbox LIVE revenue. The decreased revenue from Xbox 360 video games was due primarily to the release of two significant games in the second quarter of the prior year. We shipped 5.2 million Xbox 360 consoles during the second quarter of fiscal year 2010, compared with 6.0 million Xbox 360 consoles during the second quarter of fiscal year 2009. The decreased revenue per console resulted from price reductions during the past 12 months. Non-gaming revenue decreased $59 million or 8%, primarily reflecting decreased sales of Zune digital music and entertainment devices and Windows Mobile device platforms. Foreign currency exchange rates accounted for a $49 million or two percentage point increase in revenue.

EDD operating income increased due to reduced operating expenses. Cost of revenue decreased $478 million or 23%, primarily due to lower Xbox 360 console costs, offset in part by increased royalties to partners related to increased Xbox LIVE transactions. Sales and marketing expenses decreased $75 million or 15%, primarily due to decreased marketing for the Xbox 360 platform. Research and development expenses decreased $50 million or 10%, primarily reflecting decreased headcount-related expenses and third-party development and programming costs.

Six months ended December 31, 2009 compared with six months ended December 31, 2008

EDD revenue decreased reflecting decreases in Xbox 360 platform and PC game revenue, as well as decreased revenue from the non-gaming portion of the business. Xbox 360 platform and PC game revenue decreased by $199 million or 5% due mainly to decreased Xbox 360 consoles sold, decreased revenue per console, and decreased revenue from Xbox 360 games, offset in part by increased Xbox LIVE revenue. We shipped 7.3 million Xbox 360 consoles during the first half of fiscal year 2010, compared with 8.3 million Xbox 360 consoles during the first half of fiscal year 2009. The decreased revenue per console resulted from price reductions during the past 12 months. The decreased revenue from Xbox 360 video games was due primarily to the release of two significant games in the second quarter of the prior year. Non-gaming revenue decreased $157 million or 11%, primarily reflecting decreased sales of Zune digital music and entertainment devices and Window Mobile device platforms.

EDD operating income increased due to reduced operating expenses. Cost of revenue decreased $581 million or 19%, primarily due to lower Xbox 360 console costs, offset in part by increased royalties to partners related to increased Xbox LIVE transactions. Sales and marketing expenses decreased by $59 million or 8%, primarily due to decreased marketing for the Xbox 360 platform. Research and development expenses decreased $113 million or 12%, primarily reflecting decreased headcount-related expenses and third-party development and programming costs.

Corporate-Level Activity


(In millions, except percentages)	Three Months Ended December 31,						Percentage Change	Six Months Ended December 31,						Percentage Change


	2009			2008				2009			2008

Corporate-level activity	$	(1,291	)	$	(979	)	(32)%	$	(2,229	)	$	(2,086	)	(7)%

Certain corporate-level activity is not allocated to our segments. Those results include expenses such as broad-based sales and marketing, product support services, human resources, legal, finance, information technology, corporate development and procurement activities, research and development and other costs, and legal settlements and contingencies. Corporate-level expenses increased, primarily reflecting an increase in legal charges, offset in part by cost controls and for the six months ended December 31, 2009, by decreased partner payments. Legal charges were approximately $290 million during the three months ended December 31, 2009.


PAGE		33

PART I

Item 2

OPERATING EXPENSES

Cost of Revenue


(In millions, except percentages)	Three Months Ended December 31,						Percentage Change	Six Months Ended December 31,						Percentage Change


	2009			2008				2009			2008

Cost of revenue	$	3,628		$	3,907		(7)%	$	6,470		$	6,755		(4)%
As a percent of revenue		19	%		23	%	(4)ppt		20	%		21	%	(1)ppt

Cost of revenue includes manufacturing and distribution costs for products sold and programs licensed, operating costs related to product support service centers and product distribution centers, costs incurred to drive traffic to our websites and/or acquire online advertising space (“traffic acquisition costs”), costs incurred to support and maintain Internet-based products and services, warranty costs, inventory valuation adjustments, costs associated with the delivery of consulting services, and the amortization of capitalized research and development costs associated with software products that have reached technological feasibility. Cost of revenue decreased reflecting decreased Xbox 360 platform costs and cost controls, offset in part by increased online costs, including traffic acquisition costs.

Research and Development


(In millions, except percentages)	Three Months Ended December 31,						Percentage Change	Six Months Ended December 31,						Percentage Change


	2009			2008				2009			2008

Research and development	$	2,079		$	2,290		(9)%	$	4,144		$	4,573		(9)%
As a percent of revenue		11	%		14	%	(3)ppt		13	%		14	%	(1)ppt

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, the amortization of purchased software code and services content, and in-process research and development. The decrease in research and development expenses during the three months and six months ended December 31, 2009 was primarily driven by a decrease in third-party development and programming costs, a 3% reduction in headcount-related expenses, and the capitalization of certain software development costs.

Sales and Marketing


(In millions, except percentages)	Three Months Ended December 31,						Percentage Change	Six Months Ended December 31,						Percentage Change


	2009			2008				2009			2008

Sales and marketing	$	3,619		$	3,662		(1)%	$	6,409		$	6,706		(4)%
As a percent of revenue		19	%		22	%	(3)ppt		20	%		21	%	(1)ppt

Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel and advertising, promotions, trade shows, seminars, and other programs. Sales and marketing expenses decreased primarily as a result of decreased corporate marketing and advertising campaigns, and for the six months ended December 31, 2009, a 3% reduction in headcount-related expenses.


PAGE		34

PART I

Item 2

General and Administrative


(In millions, except percentages)	Three Months Ended December 31,						Percentage Change	Six Months Ended December 31,						Percentage Change


	2009			2008				2009			2008

General and administrative	$	1,124		$	831		35%	$	1,865		$	1,718		9%
As a percent of revenue		6	%		5	%	1ppt		6	%		5	%	1ppt

General and administrative expenses include payroll, employee benefits, stock-based compensation expense and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative headcount, and legal and other administrative fees. General and administrative expenses increased during the three months and six months ended December 31, 2009 primarily driven by increased legal charges, offset in part by an 8% decrease in headcount-related expenses for the six months ended December 31, 2009.

OTHER INCOME (EXPENSE) AND INCOME TAXES

Other Income (Expense)

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


(In millions, except percentages)	Three Months Ended December 31,						Percentage Change	Six Months Ended December 31,					Percentage Change


	2009			2008				2009		2008

Dividends and interest	$	159		$	175		(9)%	$	324	$	382		(15)%
Net recognized gains on investments		92			270		(66)%		162		399		(59)%
Net gains (losses) on derivatives		96			(409	)	*		92		(574	)	*
Net gains (losses) on foreign currency remeasurements		(23	)		(350	)	(93)%		32		(529	)	*
Other		46			13		254 %		43		13		231 %

Total	$	370		$	(301	)	*	$	653	$	(309	)	*

*	Not meaningful

Three months ended December 31, 2009 compared with three months ended December 31, 2008

Dividends and interest decreased primarily due to increased interest expense on our long-term debt and lower interest rates on our fixed-income investments, offset in part by higher average investment portfolio balances. Net recognized gains on investments decreased primarily due to sales of certain equity investments held in our strategic investments portfolio in the prior period, offset in part by lower other-than-temporary impairments. Other-than-temporary impairments were $6 million during the three months ended December 31, 2009, as compared with $262 million during the three months ended December 31, 2008 and decreased primarily due to improvements in market conditions. Net gains on derivatives increased across all asset classes in the current period as compared with losses in the prior period. Net losses from foreign currency remeasurements declined due to a weakening U.S. dollar. Other includes a gain on the divestiture of Razorfish.

Six months ended December 31, 2009 compared with six months ended December 31, 2008

Dividends and interest decreased primarily due to increased interest expense on our long-term debt and lower interest rates on our fixed-income investments, offset in part by higher average investment portfolio balances. Net recognized gains on investments decreased primarily due to sales of certain equity investments held in our strategic investments portfolio in the prior period, offset in part by lower other-than-temporary impairments. Other-than-temporary impairments were $24 million during the six months ended December 31, 2009, as compared with $334 million during the six months ended December 31, 2008 and decreased primarily due to improvements in market conditions. Net gains on derivatives increased across all asset classes as compared to the prior period. Net gains from foreign currency remeasurements compared to net losses in the prior period were due to a weakening U.S. dollar. Other includes a gain on the divestiture of Razorfish.


PAGE		35

PART I

Item 2

Income Taxes

FINANCIAL CONDITION

Cash, Cash Equivalents, and Investments

Cash, cash equivalents, and short-term investments totaled $36.1 billion as of December 31, 2009, compared with $31.4 billion as of June 30, 2009. Equity and other investments were $7.0 billion as of December 31, 2009, compared with $4.9 billion as of June 30, 2009. Our investments consist primarily of fixed-income securities, diversified among industries and individual issuers. Our investments are generally liquid and investment grade. The portfolio is invested predominantly in U.S. dollar-denominated securities, but also includes foreign currency-denominated securities in order to diversify risk. We invest primarily in short-term securities to facilitate liquidity and for capital preservation.

In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine fair value. This pricing methodology applies to our Level 1 investments, such as exchange-traded mutual funds, domestic and international equities, U.S. treasuries, and agency securities. 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 certain 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. Such controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and independent recalculation of prices where appropriate.

While we own certain mortgage- and asset-backed fixed-income securities, our portfolio as of December 31, 2009 does not contain direct exposure to subprime mortgages or structured vehicles that derive their value from subprime collateral. The majority of the mortgage-backed securities are collateralized by prime residential mortgages and carry a 100% principal and interest guarantee, primarily from Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and Government National Mortgage Association.

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 borrower. Cash received is recorded as an asset with a corresponding liability.

Debt


PAGE		36

PART I

Item 2

Short-term Debt

As of December 31, 2009, our $2.25 billion of commercial paper issued and outstanding had a weighted average interest rate, including issuance costs, of 0.14% and maturities of 16 to 210 days. In November 2009, we replaced our $2.0 billion and $1.0 billion credit facilities with a $2.25 billion 364-day credit facility, which expires on November 5, 2010. This facility serves as a back-up for our commercial paper program. As of December 31, 2009, we were in compliance with the financial covenant in the credit facility, which requires a coverage ratio maintained of at least three times earnings before interest, taxes, depreciation, and amortization to interest expense. No amounts were drawn against the credit facilities during the six months ended December 31, 2009.

Long-term Debt

We are using the net proceeds from sales of the debt securities for general corporate purposes, which may include funding for working capital, capital expenditures, repurchases of our capital stock, and acquisitions.

Unearned Revenue

Unearned revenue at December 31, 2009 comprised mainly unearned revenue from volume licensing programs. Unearned revenue from volume licensing programs represents customer billings for multi-year licensing arrangements, paid either upfront or annually at the beginning of each billing coverage period, which are accounted for as subscriptions with revenue recognized ratably over the billing coverage period. Unearned revenue at December 31, 2009 also included payments for: unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis for Windows XP; post-delivery support and consulting services to be performed in the future; Xbox LIVE subscriptions; Microsoft Dynamics business solutions products; unspecified enhancements for Zune HD; the Windows 7 Upgrade Option program; online advertising for which the advertisement has yet to be displayed; Mediaroom; and other offerings for which we have been paid upfront 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, 2009:


(In millions)


Three Months Ending,

March 31, 2010	$	4,975
June 30, 2010		3,384
September 30, 2010		1,924
December 31, 2010		1,078
Thereafter		1,167

Total	$	12,528

See Note 13 – Unearned Revenue of the Notes to Financial Statements (Part I, Item 1).

Retained Deficit

As a result of the special dividend paid in the second quarter of fiscal year 2005 and common stock repurchased, our retained deficit, including accumulated other comprehensive income, was $18.3 billion at December 31, 2009. Our retained deficit is not expected to affect our future ability to operate, pay dividends, or repay our debt given our continuing profitability and strong cash and financial position.


PAGE		37

PART I

Item 2

Cash Flows

Cash flow from operations increased $1.9 billion to $11.1 billion for the six months ended December 31, 2009. This increase was due mainly to payment of approximately $3.1 billion to the Internal Revenue Service in the prior year as a result of our settlement of the 2000-2003 audit examination, offset in part by a decrease in cash received from customers in the current year.

Cash used for financing was $6.5 billion for the six months ended December 31, 2009, a decrease of $2.6 billion from the corresponding period of the prior year. This decrease was due mainly to a $3.9 billion decrease in common stock repurchases, offset in part by a $1.7 billion decrease in net proceeds from debt and short-term borrowings.

Cash used in investing was $1.3 billion for the six months ended December 31, 2009, a decrease of $613 million from the corresponding period of the prior year. This decrease reflects lower additions to property and equipment.

Share Repurchases

During the three months and six months ended December 31, 2009, we repurchased 125 million and 183 million shares of Microsoft common stock for $3.6 billion and $5.0 billion, respectively, under the repurchase plan we announced on September 22, 2008. As of December 31, 2009, approximately $29.5 billion remained of the $40.0 billion approved repurchase amount. All repurchases were made using cash resources. The repurchase program expires September 30, 2013 but may be suspended or discontinued at any time without notice.

Dividends

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


Declaration Date	Per Share Dividend		Record Date	Total Amount		Payment Date

				(in millions)

Fiscal year 2010
September 18, 2009	$	0.13	November 19, 2009	$	1,152	December 10, 2009
December 9, 2009	$	0.13	February 18, 2010	$	1,145	March 11, 2010

Fiscal year 2009
September 19, 2008	$	0.13	November 20, 2008	$	1,157	December 11, 2008
December 10, 2008	$	0.13	February 19, 2009	$	1,155	March 12, 2009

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.

We believe existing cash, cash equivalents and short-term investments, together with funds generated from operations, should be sufficient to meet operating requirements, regular quarterly dividends, debt repayment schedules, and share repurchases. Our philosophy regarding the maintenance of a balance sheet with a large component of cash and cash equivalents, short-term investments, and equity and other investments, reflects our views on potential future capital requirements relating to research and development, creation and expansion of sales distribution channels, investments and acquisitions, share dilution management, legal risks, and challenges to our business model. We regularly assess our investment management approach in view of our current and potential future needs.


PAGE		38

PART I

Item 2

Off-Balance Sheet Arrangements

We provide indemnifications of varying scope and amount 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. To date, we have not encountered significant costs as a result of these obligations and have not accrued any liabilities related to these indemnifications in our financial statements.

RECENT ACCOUNTING GUIDANCE

Recently Adopted Accounting Guidance

Recent Accounting Guidance Not Yet Adopted

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, impairment of goodwill, accounting for research and development costs, accounting for contingencies, accounting for income taxes, accounting for stock-based compensation, and accounting for product warranties.


PAGE		39

PART I

Item 2

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 the revenue related to Windows XP is recorded as unearned due to undelivered elements including, in some cases, free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis. The amount of revenue allocated to undelivered elements is based on the VSOE of fair value for those elements using the residual method or relative fair value method. Unearned revenue due to undelivered elements is recognized ratably on a straight-line basis over the related products’ life cycles. Revenue related to Windows Vista is not subject to a similar deferral because there are no significant undelivered elements. However, Windows Vista revenue is subject to deferral as a result of the Windows 7 Upgrade Option program which started June 26, 2009. The program allowed customers who purchased certain versions of Windows Vista to receive an upgrade to the corresponding version of Windows 7 at minimal or no cost. In addition, purchasers of retail packaged Windows Vista from participating retailers in participating markets may have qualified for a free or discounted upgrade to the equivalent Windows 7 product when the product became generally available in the second quarter of fiscal year 2010. Accordingly, previously deferred revenue related to the undelivered Windows 7 product sold was recognized in the second quarter of fiscal year 2010 once the product had been delivered.

Changes to the elements in a software arrangement, the ability to identify VSOE for those elements, the fair value of the respective elements, and changes to a product’s estimated life cycle 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.

Impairment of Investment Securities

Investments are reviewed 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

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


PAGE		40

PART I

Item 2

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 should be 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 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.

Product Warranties

We provide for the estimated costs of hardware and software warranties at the time the related revenue is recognized. For hardware warranty, we estimate the costs based on historical and projected product failure rates, historical and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and country in which we do business, but generally include parts and labor over a period generally ranging from 90 days to three years. For software warranty, we estimate the costs to provide bug fixes, such as security patches, over the life of the software. We regularly reevaluate our estimates to assess the adequacy of the recorded warranty liabilities and adjust the amounts as necessary.


PAGE		41

PART I

Item 3

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

RISKS

We are exposed to economic risk from foreign currency exchange rates, interest rates, credit risk, equity prices, and commodity prices. A portion of these risks is hedged, but they may impact our results of operations, cash flows, and financial condition.

Foreign Currency

Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily and use hedges where practicable to offset the risks and maximize the economic effectiveness of our foreign currency positions. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar.

Interest Rate

Our fixed-income portfolio is diversified across credit sectors and maturities, consisting primarily of investment-grade securities. The credit risk and average maturity of the fixed-income portfolio is managed to achieve economic returns that correlate to certain global and domestic fixed-income indices. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed securities.

Equity

Our equity portfolio consists of global, developed, and emerging market securities that are subject to market price risk. We manage the securities relative to certain global and domestic indices and expect their economic risk and return to correlate with these indices.

Commodity

We use broad-based commodity exposures to enhance portfolio returns and facilitate portfolio diversification. Our investment portfolio has exposure to a variety of commodities, including precious metals, energy, and grain. We manage these exposures relative to global commodity indices and expect their economic risk and return to correlate with these indices.

VALUE-AT-RISK

We use a value-at-risk (“VaR”) model to estimate and quantify our market risks. VaR is the expected loss, for a given confidence level, in the fair value of our portfolio due to adverse market movements over a defined time horizon. The VaR model is not intended to represent actual losses in fair value, including determinations of other-than-temporary losses in fair value in accordance with U.S. GAAP, but is used as a risk estimation and management tool. The distribution of the potential changes in total market value of all holdings is computed based on the historical volatilities and correlations among foreign currency exchange rates, interest rates, equity prices, and commodity prices, assuming normal market conditions.


PAGE		42

PART I,II

Item 3,4,1

The VaR is calculated as the total loss that will not be exceeded at the 97.5 percentile confidence level or, alternatively stated, the losses could exceed the VaR in 25 out of 1,000 cases. Several risk factors are not captured in the model, including liquidity risk, operational risk, and legal risk.

The following table sets forth the one-day VaR for substantially all of our positions as of December 31, 2009 and June 30, 2009 and for the three months ended December 31, 2009:


(In millions)

	December 31, 2009	June 30, 2009		Three Months Ended December 31, 2009

Risk Categories				Average		High		Low

Foreign currency	$ 37	$	68	$	50	$	67	$	37
Interest rate	$ 49	$	42	$	48	$	51	$	45
Equity	$ 194	$	157	$	186