Edgar Filing: MICROSOFT CORP

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, 2010

¨	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 21, 2011


Common Stock, $0.00000625 par value per share		8,402,382,031 shares

MICROSOFT CORPORATION

FORM 10-Q

For the Quarter Ended December 31, 2010

INDEX


				Page
PART I.	FINANCIAL INFORMATION

	Item 1.	Financial Statements

		a)	Income Statements for the Three and Six Months Ended December 31, 2010 and 2009		3

		b)	Balance Sheets as of December 31, 2010 and June 30, 2010		4

		c)	Cash Flows Statements for the Three and Six Months Ended December 31, 2010 and 2009		5

		d)	Stockholders’ Equity Statements for the Three and Six Months Ended December 31, 2010 and 2009		6

		e)	Notes to Financial Statements		7

		f)	Report of Independent Registered Public Accounting Firm		27

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations			28

	Item 3.	Quantitative and Qualitative Disclosures About Market Risk			41

	Item 4.	Controls and Procedures			42

PART II.	OTHER INFORMATION

	Item 1.	Legal Proceedings			42

	Item 1A.	Risk Factors			43

	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds			48

	Item 6.	Exhibits			49

SIGNATURE					50

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,


	2010		2009		2010		2009

Revenue	$	19,953	$	19,022	$	36,148	$	31,942
Operating expenses:
Cost of revenue		4,833		3,628		7,972		6,470
Research and development		2,185		2,079		4,381		4,144
Sales and marketing		3,825		3,619		6,631		6,409
General and administrative		945		1,183		1,883		1,924

Total operating expenses		11,788		10,509		20,867		18,947

Operating income		8,165		8,513		15,281		12,995
Other income		332		370		446		653

Income before income taxes		8,497		8,883		15,727		13,648
Provision for income taxes		1,863		2,221		3,683		3,412

Net income	$	6,634	$	6,662	$	12,044	$	10,236


Earnings per share:
Basic	$	0.78	$	0.75	$	1.41	$	1.15
Diluted	$	0.77	$	0.74	$	1.39	$	1.14

Weighted average shares outstanding:
Basic		8,497		8,856		8,555		8,885
Diluted		8,570		8,951		8,646		8,975

Cash dividends declared per common share	$	0.16	$	0.13	$	0.32	$	0.26

See accompanying notes.

PART I

Item 1

BALANCE SHEETS


(In millions)


December 31, 2010					June 30, 2010	⁽¹⁾
(Unaudited)
Assets
Current assets:
Cash and cash equivalents	$	4,023		$	5,505
Short-term investments (including securities loaned of $982 and $62)		37,229			31,283

Total cash, cash equivalents, and short-term investments		41,252			36,788
Accounts receivable, net of allowance for doubtful accounts of $317 and $375		12,874			13,014
Inventories		861			740
Deferred income taxes		2,548			2,184
Other		2,149			2,950

Total current assets		59,684			55,676
Property and equipment, net of accumulated depreciation of $9,279 and $8,629		7,799			7,630
Equity and other investments		10,022			7,754
Goodwill		12,502			12,394
Intangible assets, net		992			1,158
Other long-term assets		1,307			1,501

Total assets	$	92,306		$	86,113

Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	$	3,863		$	4,025
Short-term debt		0			1,000
Accrued compensation		2,402			3,283
Income taxes		1,439			1,074
Short-term unearned revenue		12,063			13,652
Securities lending payable		1,355			182
Other		3,190			2,931

Total current liabilities		24,312			26,147
Long-term debt		9,671			4,939
Long-term unearned revenue		1,354			1,178
Deferred income taxes		826			229
Other long-term liabilities		7,662			7,445

Total liabilities		43,825			39,938
Commitments and contingencies
Stockholders’ equity:
Common stock and paid-in capital—shares authorized 24,000; outstanding 8,403 and 8,668		61,646			62,856
Retained deficit, including accumulated other comprehensive income of $1,697 and $1,055		(13,165	)		(16,681	)

Total stockholders’ equity		48,481			46,175

Total liabilities and stockholders’ equity	$	92,306		$	86,113

(1)	Derived from audited financial statements.

See accompanying notes.

PART I

Item 1

CASH FLOWS STATEMENTS


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


	2010			2009			2010			2009

Operations
Net income	$	6,634		$	6,662		$	12,044		$	10,236
Adjustments to reconcile net income to net cash from operations:
Depreciation, amortization, and other		663			615			1,357			1,261
Stock-based compensation expense		553			485			1,081			928
Net recognized gains on investments and derivatives		(226	)		(188	)		(255	)		(254	)
Excess tax benefits from stock-based compensation		(4	)		(15	)		(9	)		(24	)
Deferred income taxes		(117	)		550			(265	)		504
Deferral of unearned revenue		6,834			6,926			12,715			13,605
Recognition of unearned revenue		(7,301	)		(9,126	)		(14,163	)		(15,363	)
Changes in operating assets and liabilities:
Accounts receivable		(3,270	)		(2,789	)		404			(41	)
Inventories		380			558			(88	)		139
Other current assets		(77	)		686			131			451
Other long-term assets		118			16			180			(62	)
Accounts payable		216			3			(184	)		(33	)
Other current liabilities		(500	)		282			(1,411	)		(921	)
Other long-term liabilities		283			304			843			650

Net cash from operations		4,186			4,969			12,380			11,076

Financing
Short-term debt repayments, maturities of 90 days or less, net		(1,000	)		(475	)		(186	)		(97	)
Proceeds from issuance of debt, maturities longer than 90 days		0			1,046			4,721			1,741
Repayments of debt, maturities longer than 90 days		0			(573	)		(814	)		(1,396	)
Common stock issued		660			729			837			977
Common stock repurchased		(5,052	)		(3,867	)		(9,451	)		(5,407	)
Common stock cash dividends paid		(1,363	)		(1,152	)		(2,481	)		(2,309	)
Excess tax benefits from stock-based compensation		4			15			9			24
Other		0			0			(25	)		0

Net cash used in financing		(6,751	)		(4,277	)		(7,390	)		(6,467	)

Investing
Additions to property and equipment		(491	)		(376	)		(1,055	)		(811	)
Acquisition of companies, net of cash acquired		(69	)		(63	)		(69	)		(102	)
Purchases of investments		(5,896	)		(4,287	)		(13,313	)		(14,777	)
Maturities of investments		1,836			1,896			2,706			5,394
Sales of investments		2,603			3,361			4,030			7,778
Securities lending payable		447			(623	)		1,174			1,227

Net cash used in investing		(1,570	)		(92	)		(6,527	)		(1,291	)

Effect of exchange rates on cash and cash equivalents		(3	)		(1	)		55			28

Net change in cash and cash equivalents		(4,138	)		599			(1,482	)		3,346
Cash and cash equivalents, beginning of period		8,161			8,823			5,505			6,076

Cash and cash equivalents, end of period	$	4,023		$	9,422		$	4,023		$	9,422

See accompanying notes.

PART I

Item 1

STOCKHOLDERS’ EQUITY STATEMENTS


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


	2010			2009			2010			2009

Common stock and paid-in capital
Balance, beginning of period	$	61,935		$	62,293		$	62,856		$	62,382
Common stock issued		660			779			837			1,027
Common stock repurchased		(1,405	)		(923	)		(2,980	)		(1,656	)
Stock-based compensation		553			485			1,081			928
Stock-based compensation income tax deficiencies		(97	)		(68	)		(148	)		(115	)

Balance, end of period		61,646			62,566			61,646			62,566

Retained deficit
Balance, beginning of period		(14,993	)		(21,081	)		(16,681	)		(22,824	)
Net income		6,634			6,662			12,044			10,236
Other comprehensive income:
Net unrealized losses on derivatives		(80	)		(42	)		(586	)		(361	)
Net unrealized gains on investments		284			65			1,016			653
Translation adjustments and other		(26	)		(35	)		212			61

Comprehensive income		6,812			6,650			12,686			10,589
Common stock cash dividends		(1,337	)		(1,140	)		(2,699	)		(2,297	)
Common stock repurchased		(3,647	)		(2,712	)		(6,471	)		(3,751	)

Balance, end of period		(13,165	)		(18,283	)		(13,165	)		(18,283	)

Total stockholders’ equity	$	48,481		$	44,283		$	48,481		$	44,283

See accompanying notes.

PART I

Item 1

NOTES TO FINANCIAL STATEMENTS

(Unaudited)

NOTE 1 ACCOUNTING POLICIES

Basis of Presentation and Use of Estimates

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 2010 Form 10-K filed on July 30, 2010 with the U.S. Securities and Exchange Commission.

Principles of Consolidation

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

Recently Adopted Accounting Guidance

On July 1, 2010, we adopted guidance issued by the Financial Accounting Standards Board (“FASB”) on revenue recognition. 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 are no longer within the scope of the software revenue recognition guidance, and software-enabled products are now 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. Adoption of the new guidance did not have a material impact on our financial statements.

On July 1, 2010, we also adopted guidance issued by the FASB on the consolidation of variable interest entities. 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. Adoption of the new guidance did not have a material impact on our financial statements.

Recent Accounting Guidance Not Yet Adopted

In January 2010, the FASB issued guidance to amend the disclosure requirements related to fair value measurements. The guidance requires the disclosure of roll forward activities on purchases, sales, issuance, and settlements of the assets and liabilities measured using significant unobservable inputs (Level 3 fair value measurements). The guidance will become effective for us with the reporting period beginning July 1, 2011. Other than requiring additional disclosures, the adoption of this new guidance will not have a material impact on our financial statements.

PART I

Item 1

NOTE 2 EARNINGS PER SHARE

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


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


	2010		2009		2010		2009

Net income available for common shareholders (A)	$	6,634	$	6,662	$	12,044	$	10,236

Weighted average shares of common stock (B)		8,497		8,856		8,555		8,885
Dilutive effect of stock-based awards		73		95		91		90

Common stock and common stock equivalents (C)		8,570		8,951		8,646		8,975

Earnings Per Share:
Basic (A/B)	$	0.78	$	0.75	$	1.41	$	1.15
Diluted (A/C)	$	0.77	$	0.74	$	1.39	$	1.14

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,

2010

2009

2010

2009

Shares excluded from calculations of diluted EPS

101

155

The decrease in anti-dilutive shares is due mainly to the decrease in employee stock options outstanding.

In June 2010, we issued $1.25 billion of zero-coupon debt securities that are convertible into shares of our common stock if certain conditions are met. Shares of common stock into which the debt could convert were excluded from the calculation of diluted earnings per share because their inclusion would have been anti-dilutive. See also Note 10 – Debt.

NOTE 3 OTHER INCOME

The components of other income were as follows:


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


	2010			2009			2010			2009

Dividends and interest income	$	205		$	197		$	415		$	400
Interest expense		(72	)		(38	)		(117	)		(76	)
Net recognized gains on investments		118			92			152			162
Net gains on derivatives		108			96			103			92
Net gains (losses) on foreign currency remeasurements		(27	)		(23	)		(69	)		32
Other		0			46			(38	)		43

Total	$	332		$	370		$	446		$	653

PART I

Item 1

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, 2010
Cash	$	1,811	$	0	$	0		$	1,811	$	1,811	$	0	$	0
Mutual funds		367		0		0			367		367		0		0
Certificates of deposit		1,100		0		0			1,100		742		358		0
U.S. Government and Agency securities		26,535		137		(7	)		26,665		1,103		25,562		0
Foreign government bonds		553		13		0			566		0		566		0
Mortgage-backed securities		2,629		112		(6	)		2,735		0		2,735		0
Corporate notes and bonds		7,118		311		(14	)		7,415		0		7,415		0
Municipal securities		527		4		(5	)		526		0		526		0
Common and preferred stock		7,197		2,337		(107	)		9,427		0		0		9,427
Other investments		662		0		0			662		0		67		595

Total	$	48,499	$	2,914	$	(139	)	$	51,274	$	4,023	$	37,229	$	10,022


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


June 30, 2010
Cash	$	1,661	$	0	$	0		$	1,661	$	1,661	$	0	$	0
Mutual funds		1,120		0		0			1,120		1,120		0		0
Commercial paper		188		0		0			188		13		175		0
Certificates of deposit		348		0		0			348		68		280		0
U.S. Government and Agency securities		21,036		167		(1	)		21,202		1,822		19,380		0
Foreign government bonds		518		13		0			531		0		531		0
Mortgage-backed securities		3,137		135		(7	)		3,265		0		3,265		0
Corporate notes and bonds		7,450		289		(18	)		7,721		701		7,020		0
Municipal securities		726		22		(1	)		747		120		627		0
Common and preferred stock		6,640		1,030		(418	)		7,252		0		0		7,252
Other investments		507		0		0			507		0		5		502

Total	$	43,331	$	1,656	$	(445	)	$	44,542	$	5,505	$	31,283	$	7,754

PART I

Item 1

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, 2010

U.S. Government and Agency securities	$	2,013	$	(7	)	$	0	$	0		$	2,013	$	(7	)
Mortgage-backed securities		79		(5	)		16		(1	)		95		(6	)
Corporate notes and bonds		635		(13	)		70		(1	)		705		(14	)
Municipal securities		255		(5	)		0		0			255		(5	)
Common and preferred stock		951		(80	)		193		(27	)		1,144		(107	)

Total	$	3,933	$	(110	)	$	279	$	(29	)	$	4,212	$	(139	)


	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, 2010

U.S. Government and Agency securities	$	216	$	(1	)	$	0	$	0		$	216	$	(1	)
Mortgage-backed securities		105		(6	)		18		(1	)		123		(7	)
Corporate notes and bonds		1,124		(13	)		89		(5	)		1,213		(18	)
Municipal securities		66		(1	)		0		0			66		(1	)
Common and preferred stock		2,102		(339	)		190		(79	)		2,292		(418	)

Total	$	3,613	$	(360	)	$	297	$	(85	)	$	3,910	$	(445	)

Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic and international equities are due to market price movements. Management does not believe any remaining unrealized losses represent other-than-temporary impairments based on our evaluation of available evidence as of December 31, 2010.

At December 31, 2010 and June 30, 2010, 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 $279 million and $216 million, respectively.

Debt Investment Maturities


(In millions)	Cost Basis		Estimated Fair Value


December 31, 2010

Due in one year or less	$	21,169	$	21,273
Due after one year through five years		11,677		11,887
Due after five years through 10 years		2,397		2,513
Due after 10 years		3,219		3,334

Total	$	38,462	$	39,007

PART I

Item 1

NOTE 5 DERIVATIVES

We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; to enhance investment returns; and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible.

Our derivative programs include strategies that both qualify and do not qualify for hedge accounting treatment. All notional amounts presented below are measured in U.S. currency equivalents.

Foreign Currency

Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge positions. Option and forward contracts are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash flow hedging instruments. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. As of December 31, 2010 and June 30, 2010, the total notional amounts of these foreign exchange contracts sold were $11.6 billion and $9.3 billion, respectively.

Foreign currency risks related to certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are designated as fair value hedging instruments. As of December 31, 2010 and June 30, 2010, the total notional amounts of these foreign exchange contracts sold were $543 million and $523 million, respectively.

Certain options and forwards not designated as hedging instruments are also used to manage the variability in exchange rates on accounts receivable, cash, and intercompany positions, and to manage other foreign currency exposures. As of December 31, 2010, the total notional amounts of these foreign exchange contracts purchased and sold were $4.5 billion and $6.1 billion, respectively. As of June 30, 2010, the total notional amounts of these foreign exchange contracts purchased and sold were $7.8 billion and $5.3 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, 2010, the total notional amounts of designated and non-designated equity contracts purchased and sold were $1.5 billion and $1.1 billion, respectively. As of June 30, 2010, the total notional amounts of designated and non-designated equity contracts purchased and sold were $918 million and $472 million, respectively.

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, 2010, the total notional amounts of fixed-interest rate contracts purchased and sold were $1.0 billion and $433 million, respectively. As of June 30, 2010, the total notional amounts of fixed-interest rate contracts purchased and sold were $3.1 billion and $1.8 billion, 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, 2010 and June 30, 2010, the total notional derivative amount of mortgage contracts purchased were $645 million and $305 million, respectively.

Credit

Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts, not designated as hedging instruments, to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. We use credit default swaps as they are a low cost method of managing exposure to individual credit risks or groups of credit risks. As of December 31, 2010 and June 30, 2010, the total notional amounts of credit contracts purchased and sold were immaterial.

PART I

Item 1

Commodity

We use broad-based commodity exposures to enhance portfolio returns and to facilitate portfolio diversification. We use swap, futures and option contracts, not designated as hedging instruments, to generate and manage exposures to broad-based commodity indices. We use derivatives on commodities as they can be low-cost alternatives to the purchase and storage of a variety of commodities, including, but not limited to, precious metals, energy, and grain. As of December 31, 2010, the total notional amounts of commodity contracts purchased and sold were $1.4 billion and $456 million, respectively. As of June 30, 2010, the total notional amounts of commodity contracts purchased and sold were $1.1 billion and $376 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, 2010, our long-term unsecured debt rating was AAA, and cash investments were in excess of $1.0 billion. As a result, no collateral was required to be posted.

Fair Values of Derivative Instruments

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

For 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.

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

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

Following are the gross fair values of derivative instruments designated as hedging instruments (“designated hedge derivatives”) and not designated as hedging instruments (“non-designated hedge derivatives”) that were held at December 31, 2010 and June 30, 2010. The fair values exclude the impact of netting derivative assets and liabilities when a legally enforceable master netting agreement exists and fair value adjustments related to our own credit risk and counterparty credit risk.

PART I

Item 1


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


December 31, 2010

Assets
Non-designated hedge derivatives:
Short-term investments	$	12		$	173		$	18		$	11		$	96		$	310
Other current assets		46			0			0			0			0			46

Total	$	58		$	173		$	18		$	11		$	96		$	356
Designated hedge derivatives:
Short-term investments	$	2		$	0		$	0		$	0		$	0		$	2
Other current assets		142			0			0			0			0			142

Total	$	144		$	0		$	0		$	0		$	0		$	144

Total assets	$	202		$	173		$	18		$	11		$	96		$	500

Liabilities
Non-designated hedge derivatives:
Other current liabilities	$	(48	)	$	(11	)	$	(6	)	$	(13	)	$	(34	)	$	(112	)
Designated hedge derivatives:
Other current liabilities	$	(358	)	$	0		$	0		$	0		$	0		$	(358	)

Total liabilities	$	(406	)	$	(11	)	$	(6	)	$	(13	)	$	(34	)	$	(470	)


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


June 30, 2010

Assets
Non-designated hedge derivatives:
Short-term investments	$	15		$	134		$	12		$	7		$	8		$	176
Other current assets		34			0			0			0			0			34

Total	$	49		$	134		$	12		$	7		$	8		$	210
Designated hedge derivatives:
Short-term investments	$	3		$	0		$	0		$	0		$	0		$	3
Other current assets		563			0			0			0			0			563

Total	$	566		$	0		$	0		$	0		$	0		$	566

Total assets	$	615		$	134		$	12		$	7		$	8		$	776

Liabilities
Non-designated hedge derivatives:
Other current liabilities	$	(60	)	$	(17	)	$	(33	)	$	(41	)	$	(5	)	$	(156	)
Designated hedge derivatives:
Other current liabilities	$	(9	)	$	0		$	0		$	0		$	0		$	(9	)

Total liabilities	$	(69	)	$	(17	)	$	(33	)	$	(41	)	$	(5	)	$	(165	)

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

PART I

Item 1

Fair Value Hedges

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


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


	2010			2009			2010			2009

Derivatives	$	2		$	89		$	(50	)	$	(104	)
Hedged items		(2	)		(85	)		48			103

Total	$	0		$	4		$	(2	)	$	(1	)

Cash Flow Hedges

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


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


	2010			2009		2010			2009

Effective Portion
Gain (loss) recognized in OCI, net of tax effect of $(24) for the three months ended and $(267) for the six months ended December 31, 2010, and $1 for the three months and $(111) for the six months ended December 31, 2009	$	(45	)	$	2	$	(497	)	$	(207	)
Gain reclassified from OCI into revenue		55			68		139			237

Amount Excluded from Effectiveness Assessment and Ineffective Portion
Gain (loss) recognized in other income		(16	)		26		(103	)		(14	)

We estimate that $104 million of net derivative losses 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, 2010 and 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, 2010 and 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.


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


	2010			2009		2010			2009

Foreign exchange contracts	$	(25	)	$	47	$	(85	)	$	90
Equity contracts		(2	)		7		31			16
Interest-rate contracts		24			9		12			12
Credit contracts		10			2		28			11
Commodity contracts		93			54		158			69

Total	$	100		$	119	$	144		$	198

PART I

Item 1

NOTE 6 FAIR VALUE MEASUREMENTS

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

•

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

•

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

•

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

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

PART I

Item 1

Assets and Liabilities Measured at Fair Value on a Recurring Basis

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



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


December 31, 2010

Assets
Mutual funds	$	367	$	0	$	0	$	367	$	0		$	367
Certificates of deposit		0		1,100		0		1,100		0			1,100
U.S. Government and Agency securities		20,722		5,942		0		26,664		0			26,664
Foreign government bonds		257		316		0		573		0			573
Mortgage-backed securities		0		2,736		0		2,736		0			2,736
Corporate notes and bonds		0		7,067		171		7,238		0			7,238
Municipal securities		0		526		0		526		0			526
Common and preferred stock		9,085		58		5		9,148		0			9,148
Derivatives		17		468		15		500		(325	)		175

Total	$	30,448	$	18,213	$	191	$	48,852	$	(325	)	$	48,527

Liabilities
Derivatives and other	$	93	$	456	$	0	$	549	$	(325	)	$	224


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


June 30, 2010

Assets
Mutual funds	$	1,120	$	0	$	0	$	1,120	$	0		$	1,120
Commercial paper		0		172		0		172		0			172
Certificates of deposit		0		348		0		348		0			348
U.S. Government and Agency securities		16,473		4,756		0		21,229		0			21,229
Foreign government bonds		239		294		0		533		0			533
Mortgage-backed securities		0		3,264		0		3,264		0			3,264
Corporate notes and bonds		0		7,460		167		7,627		0			7,627
Municipal securities		0		747		0		747		0			747
Common and preferred stock		6,988		43		5		7,036		0			7,036
Derivatives		22		745		9		776		(207	)		569

Total	$	24,842	$	17,829	$	181	$	42,852	$	(207	)	$	42,645

Liabilities
Derivatives and other	$	85	$	137	$	0	$	222	$	(205	)	$	17

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

PART I

Item 1

The table below reconciles the total Net Fair Value of assets above to the balance sheet presentation of these same assets in Note 4 – Investments for December 31, 2010 and June 30, 2010.


(In millions)


	December 31, 2010			June 30, 2010

Net fair value of assets measured at fair value on a recurring basis	$	48,527		$	42,645
Cash		1,811			1,661
Common and preferred stock measured at fair value on a nonrecurring basis		279			216
Other investments measured at fair value on a nonrecurring basis		596			502
Less derivative assets classified as other current assets		(16	)		(544	)
Other		77			62

Recorded basis of investment components	$	51,274		$	44,542

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, 2010 and 2009 in our Level 3 financial instruments that are measured at fair value on a recurring basis. The majority of these instruments consist of investment securities classified as available-for-sale with changes in fair value included in OCI.


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


Three Months and Six Months Ended December 31, 2010

Balance as of June 30, 2010	$	167		$	5	$	9		$	181
Total realized and unrealized gains (losses):
Included in other income (expense)		2			0		7			9
Included in other comprehensive income		(2	)		0		0			(2	)

Balance as of September 30, 2010	$	167		$	5	$	16		$	188
Total realized and unrealized gains:
Included in other income (expense)		2			0		(1	)		1
Included in other comprehensive income		2			0		0			2

Balance as of December 31, 2010	$	171		$	5	$	15		$	191

Change in unrealized gains (losses) included in other income (expense) for the three months ended December 31, 2010 related to assets held as of December 31, 2010	$	2		$	0	$	(1	)	$	1
Change in unrealized gains (losses) included in other income (expense) for the six months ended December 31, 2010 related to assets held as of December 31, 2010	$	4		$	0	$	6		$	10

PART I

Item 1


(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			0		(2	)		(1	)
Included in other comprehensive income		(74	)		0		0			(74	)

Balance as of September 30, 2009	$	180		$	5	$	3		$	188
Total realized and unrealized gains:
Included in other income (expense)		1			0		1			2
Included in other comprehensive income		11			0		0			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		$	0	$	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		$	0	$	(1	)	$	1

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

During the three months and six months ended December 31, 2010 and 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.

NOTE 7 INVENTORIES

The components of inventories were as follows:


(In millions)


December 31, 2010			June 30, 2010

Raw materials	$	151	$	172
Work in process		54		16
Finished goods		656		552

Total	$	861	$	740

PART I

Item 1

NOTE 8 GOODWILL

Changes in our goodwill balances during the three months and six months ended December 31, 2010 were as follows:


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


September 30, 2010			December 31, 2010

Windows & Windows Live Division	$	89	$	0	$	0		$	89
Server and Tools		1,125		13		0			1,138
Online Services Division		6,373		0		0			6,373
Microsoft Business Division		4,102		0		(11	)		4,091
Entertainment and Devices Division		782		30		(1	)		811

Total	$	12,471	$	43	$	(12	)	$	12,502


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


June 30, 2010			December 31, 2010

Windows & Windows Live Division	$	77	$	0	$	12		$	89
Server and Tools		1,118		13		7			1,138
Online Services Division		6,373		0		0			6,373
Microsoft Business Division		4,024		0		67			4,091
Entertainment and Devices Division		802		30		(21	)		811

Total	$	12,394	$	43	$	65		$	12,502

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

NOTE 9 INTANGIBLE ASSETS

The components of intangible assets were as follows:


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


	December 31, 2010							June 30, 2010

Contract-based	$	1,067	$	(935	)	$	132	$	1,075	$	(914	)	$	161
Technology-based		2,321		(1,639	)		682		2,308		(1,521	)		787
Marketing-related		113		(91	)		22		114		(86	)		28
Customer-related		392		(236	)		156		390		(208	)		182

Total	$	3,893	$	(2,901	)	$	992	$	3,887	$	(2,729	)	$	1,158

PART I

Item 1

Intangible assets amortization expense was $126 million for the three months and $250 million for the six months ended December 31, 2010 as compared with $169 million for the three months and $318 million for the six months ended December 31, 2009. The following table outlines the estimated future amortization expense related to intangible assets held at December 31, 2010:


(In millions)


Year Ending June 30,

2011 (excluding the six months ended December 31, 2010)	$	252
2012		392
2013		251
2014		57
2015		16
2016 and thereafter		24

Total	$	992

NOTE 10 DEBT

Short-term Debt

During the three months ended December 31, 2010, we repaid $1.0 billion of commercial paper, leaving zero outstanding.

On November 5, 2010, our $1.0 billion 364-day credit facility expired. This facility served as a back-up for our commercial paper program. No amounts were drawn against the credit facility during any of the periods presented.

Long-term Debt

As of December 31, 2010, the total carrying value and estimated fair value of our long-term debt, including convertible debt, were $9.7 billion and $9.8 billion, respectively. The estimated fair value is based on quoted prices for our publicly-traded debt as of December 31, 2010, as applicable.

The components of long-term debt and the associated interest rates and semi-annual interest record and payment dates were as follows as of December 31, 2010:

Due Date

Face Value

Interest Rate

Record Date

Pay Date

Record Date

Pay Date

Notes

(In millions)

September 27, 2013

1,000

0.875

March 15

March 27

September 15

September 27

June 1, 2014

2,000

2.950

May 15

June 1

November 15

December 1

September 25, 2015

1,750

1.625

March 15

March 25

September 15

September 25

June 1, 2019

1,000

4.200

May 15

June 1

November 15

December 1

October 1, 2020

1,000

3.000

March 15

April 1

September 15

October 1

June 1, 2039

750

5.200

May 15

June 1

November 15

December 1

October 1, 2040

1,000

4.500

March 15

April 1

September 15

October 1

Convertible Debt

June 15, 2013

1,250

0.000

Total unamortized discount

(79

)

Total

9,671

Notes

As of December 31, 2010, we had issued and outstanding $8.5 billion of debt securities as illustrated in the table above (collectively “the Notes”), including $4.75 billion of debt securities issued in September 2010. The Notes are senior unsecured obligations and rank equally with our other unsecured and unsubordinated debt outstanding.

PART I

Item 1

Convertible Debt

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

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

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

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

NOTE 11 INCOME TAXES

Our effective tax rates were approximately 22% and 25% for the three months ended December 31, 2010 and 2009, respectively, and 23% and 25% for the six months ended December 31, 2010 and 2009, respectively. The reduction in the rate was due to a higher mix of earnings taxed at lower rates in foreign jurisdictions, and the retroactive extension of the research and development tax credit in the United States. Tax contingencies and other tax liabilities were $6.9 billion as of December 31, 2010 and June 30, 2010, and were included in other long-term liabilities.

NOTE 12 UNEARNED REVENUE

The components of unearned revenue were as follows:


(In millions)


December 31, 2010			June 30, 2010

Volume licensing programs	$	11,119	$	12,180
Undelivered elements		221		624
Other		2,077		2,026

Total	$	13,417	$	14,830

Unearned revenue by segment was as follows:


(In millions)


December 31, 2010			June 30, 2010

Windows & Windows Live Division	$	1,467	$	1,701
Server and Tools		4,938		5,282
Microsoft Business Division		6,171		7,004
Other segments		841		843

Total	$	13,417	$	14,830

PART I

Item 1

NOTE 13 COMMITMENTS AND GUARANTEES

Yahoo! Commercial Agreement

On December 4, 2009, we entered into a definitive agreement with Yahoo! whereby Microsoft will provide the exclusive algorithmic and paid search platform for Yahoo! Web sites. The term of the agreement is 10 years subject to termination provisions after five years based on performance.

Microsoft provided Yahoo! with revenue per search guarantees for a period of 18 months after implementation of the Microsoft search ads platform in each country. These guarantees are calculated, paid and trued-up periodically based on the cumulative reduction in revenue per search, if any, during the 18 month period from pre-implementation levels, except in the case of the U.S. and Canada where performance during each of the first two calendar quarters after implementation is independent and not cumulative. This is a rate guarantee and not a guarantee of search volume. We estimate the total cost of the revenue per search guarantees during the guarantee period could range up to $150 million.

Microsoft also agreed to reimburse Yahoo! for certain transition expenses incurred both before and after the effective date of the agreement.

Finally, Microsoft also agreed to reimburse Yahoo! for certain costs of running algorithmic and paid search services prior to migration to Microsoft’s platform.

Product Warranty

Our aggregate product warranty liabilities, which are included in other current liabilities and other long-term liabilities, changed during the three months and six months ended December 31, 2010 as follows:


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


	2010			2009			2010			2009

Balance, beginning of period	$	214		$	289		$	240		$	342
Accrual for warranties issued		19			61			32			94
Adjustments to pre-existing warranties		0			(2	)		0			(2	)
Settlements of warranty claims		(31	)		(40	)		(70	)		(126	)

Balance, end of period	$	202		$	308		$	202		$	308

NOTE 14 CONTINGENCIES

Government Competition Law Matters

We are 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.

The settlements in all states have received final court approval. Under the settlements, generally class members can obtain vouchers that entitle them to be reimbursed for purchases of a wide variety of platform-neutral computer hardware and software. The total value of vouchers that we may issue varies by state. We will make available to certain schools a percentage of those vouchers that are not issued or claimed (one-half to two-thirds depending on the state). The total value of vouchers we ultimately issue will depend on the number of class members who make

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claims and are issued vouchers. The maximum value of vouchers to be issued is approximately $2.7 billion. The actual costs of these settlements will be less than that maximum amount, depending on the number of class members and schools that are issued and redeem vouchers. We estimate the total cost to resolve all of the state overcharge class action cases will range between $1.9 billion and $2.0 billion. At December 31, 2010, we have recorded a liability related to these claims of approximately $593 million, which reflects our estimated exposure of $1.9 billion less payments made to date of approximately $1.3 billion mostly for vouchers, legal fees, and administrative expenses.

The three cases pending in British Columbia, Ontario, and Quebec, Canada have not been settled. In March 2010, the court in the British Columbia case certified it as a class action. We have appealed this ruling. The other two actions have been stayed.

Other Antitrust Litigation and Claims

In November 2004, Novell, Inc. filed a complaint in U.S. District Court for the District of Utah (later transferred to federal court in Maryland), asserting antitrust and unfair competition claims against us related to Novell’s ownership of WordPerfect and other productivity applications during the period between June 1994 and March 1996. In June 2005, the trial court granted our motion to dismiss four of six claims of the complaint. In March 2010 the trial court granted summary judgment in favor of Microsoft as to all remaining claims. Novell has appealed that ruling.

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 September 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. Trial on the remanded damages claim is set to begin in July 2011.

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

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. In December 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. In November 2010, the U.S. Supreme Court granted our petition seeking review of the case; we expect oral argument in April 2011 and a decision in June 2011.

In October 2010, we filed suit against Motorola with the International Trade Commission and in U.S. District Court in Washington for infringement of nine Microsoft patents by Motorola’s Android-based smartphones. In addition, in November 2010, we filed suit against Motorola in U.S. District Court in Washington for breach of Motorola’s contractual commitments to the Institute of Electrical and Electronics Engineers (IEEE) and International Telecommunications Union (ITU) to license identified patents related to wireless and video coding technologies under reasonable and non-discriminatory terms and conditions. In November 2010, Motorola filed two patent infringement actions against us in U.S. District Court in Wisconsin and one in U.S. District Court in Florida on a total of sixteen patents asserted variously against Windows, Windows Phone 7, Windows Mobile 6.5, Xbox, Bing Maps, Hotmail, Messenger and Exchange Server.

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In addition to these cases, there are approximately 45 other patent infringement cases pending against Microsoft.

Other

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

As of December 31, 2010, we had accrued aggregate liabilities of $877 million in other current liabilities and $336 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 reach approximately $950 million 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 15 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,

2010

2009

2010

2009

Shares of common stock repurchased

188

125

351

183

Value of common stock repurchased

5,000

3,583

9,000

5,028

We repurchased all shares with cash resources. As of December 31, 2010, approximately $14.7 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 2011

September 21, 2010

0.16

November 18, 2010

1,363

December 9, 2010

December 15, 2010

0.16

February 17, 2011

1,344

March 10, 2011

Fiscal year 2010

September 18, 2009

0.13

November 19, 2009

1,152

December 10, 2009

December 9, 2009

0.13

February 18, 2010

1,139

March 11, 2010

The estimate of the amount to be paid as a result of the December 15, 2010 declaration was included in other current liabilities as of December 31, 2010.

NOTE 16 SEGMENT INFORMATION

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

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

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

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.

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,


	2010			2009			2010			2009

Revenue
Windows & Windows Live Division	$	4,985		$	5,361		$	9,690		$	9,590
Server and Tools		4,392			3,980			8,354			7,528
Online Services Division		691			578			1,218			1,065
Microsoft Business Division		5,811			4,868			10,908			9,367
Entertainment and Devices Division		3,653			2,417			5,422			3,850
Unallocated and other		421			1,818			556			542

Consolidated	$	19,953		$	19,022		$	36,148		$	31,942

Operating income (loss)
Windows & Windows Live Division	$	3,189		$	3,575		$	6,393		$	6,392
Server and Tools		1,758			1,421			3,352			2,610
Online Services Division		(562	)		(477	)		(1,140	)		(973	)
Microsoft Business Division		3,731			2,924			7,038			5,687
Entertainment and Devices Division		636			363			1,002			623
Reconciling amounts		(587	)		707			(1,364	)		(1,344	)

Consolidated	$	8,165		$	8,513		$	15,281		$	12,995

Reconciling amounts in the tables above and below include adjustments to conform our internal accounting policies to 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, depreciation, and amortization of stock-based awards.

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Significant reconciling items were as follows:


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


	2010			2009			2010			2009

Corporate-level activity^(a)	$	(963	)	$	(1,217	)	$	(2,011	)	$	(2,052	)
Stock-based compensation		65			108			244			268
Revenue reconciling amounts^(b)		333			1,791			464			428
Other		(22	)		25			(61	)		12

Total	$	(587	)	$	707		$	(1,364	)	$	(1,344	)

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

(b)

For the three months ended December 31, 2009, revenue 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.

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.

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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, 2010, and the related consolidated statements of income, cash flows, and stockholders’ equity for the three-month and six-month periods ended December 31, 2010 and 2009. 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, 2010, and the related consolidated statements of income, cash flows, and stockholders’ equity for the year then ended (not presented herein); and in our report dated July 30, 2010 we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of June 30, 2010 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 27, 2011

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

NOTE ABOUT FORWARD-LOOKING STATEMENTS

Certain statements in this report, other than purely historical information, including estimates, projections, statements relating to our business plans, objectives and expected operating results, and the assumptions upon which those statements are based, are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may appear throughout this report, including without limitation, the following sections: “Management’s Discussion and Analysis”, and “Risk Factors.” These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially from the forward-looking statements. A detailed discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section titled “Risk Factors” (refer to Part II, Item 1A of this Form 10-Q). 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, 2010 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 gaming and entertainment console and accessories, and Microsoft PC hardware products. Online offerings and information are delivered to consumers through Bing, Windows Live, Xbox LIVE, Microsoft Office Web Apps, our MSN portals and channels, and to businesses through Microsoft Online Services offerings, such as Microsoft Dynamics CRM Online, Exchange Online, and SharePoint Online, and through Windows Azure and SQL Azure. 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 discussions below regarding the deferral of revenue related to sales of Windows Vista with a guarantee to be upgraded to Windows 7 at minimal or no cost and of Windows 7 to retailers before general availability (the “Windows 7 Deferral”) and sales of earlier versions of the Microsoft Office system with a guarantee to be upgraded to the newest version of the Microsoft Office system at minimal or no cost (the “Office Deferral”).

Global macroeconomic factors have a strong correlation to demand for our software, services, hardware, and online offerings. The current macroeconomic factors remain dynamic and uncertain. Irrespective of global economic conditions, we are positive about our relative market position, our current product portfolio, and future product pipeline. Because we offer a wide range of products and services that enable companies to improve productivity and reduce costs, including cloud-based services, we believe that Microsoft is well-positioned to create new opportunities to increase revenue as the global economy improves. 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.

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All growth and percentage comparisons refer to the three months and six months ended December 31, 2010, as compared with the three months and six months ended December 31, 2009, unless otherwise noted.

RESULTS OF OPERATIONS

Summary


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


	2010		2009				2010		2009

Revenue	$	19,953	$	19,022		5%	$	36,148	$	31,942		13%
Operating income	$	8,165	$	8,513		(4)%	$	15,281	$	12,995		18%
Diluted earnings per share	$	0.77	$	0.74		4%	$	1.39	$	1.14		22%

Three months ended December 31, 2010 compared with three months ended December 31, 2009

Revenue increased primarily due to strong sales of the Xbox 360 console and accessories, including Kinect, the 2010 Microsoft Office system, and Server and Tools products. This increase was offset in part by the recognition in the prior year of approximately $1.7 billion of revenue related to the Windows 7 Deferral. Changes in foreign currency exchange rates had an insignificant impact on revenue.

Operating income decreased reflecting higher operating expenses, offset in part by the change in revenue. Key changes in operating expenses were:

•

Cost of revenue increased $1.2 billion or 33%, primarily reflecting increased volumes of Xbox 360 consoles and accessories sold and higher costs associated with our online offerings.

•

General and administrative expenses decreased $238 million or 20%, due mainly to a decrease in legal charges and employee severance, offset in part by higher headcount-related expenses.

•

Sales and marketing expenses increased $206 million or 6%, primarily reflecting increased advertising and marketing of the Xbox 360 platform, Windows Phone, and Windows and Windows Live.

•

Research and development expenses increased $106 million or 5%, due mainly to higher headcount-related expenses.

Six months ended December 31, 2010 compared with six months ended December 31, 2009

Revenue increased primarily due to strong sales of the Xbox 360 console, accessories and video games, the 2010 Microsoft Office system, and Server and Tools products. Changes in foreign currency exchange rates had an insignificant impact on revenue.

Operating income increased reflecting the change in revenue, offset in part by higher operating expenses. Key changes in operating expenses were:

•

Cost of revenue increased $1.5 billion or 23%, primarily reflecting increased volumes of Xbox 360 consoles and accessories sold and higher costs associated with our online offerings.

•

Research and development expenses increased $237 million or 6%, due mainly to higher headcount-related expenses and third-party development and programming costs.

•

Sales and marketing expenses increased $222 million or 3%, primarily reflecting increased advertising and marketing of the Xbox 360 platform, Windows Phone, and Windows and Windows Live, and higher headcount-related 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 U.S. (“U.S. GAAP”) and include certain reconciling items attributable to each of the segments. Segment information appearing in Note 16 – Segment Information of the Notes to Financial Statements (Part I, Item I of this Form 10-Q) is presented on a basis consistent with our current internal management

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reporting. Certain corporate-level activity has been excluded from segment operating results and is analyzed separately. We have recast certain prior period amounts within this MD&A to conform to the way we internally managed and monitored segment performance during the current fiscal year.

Windows & Windows Live Division


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


	2010		2009				2010		2009

Revenue	$	5,054	$	7,193		(30)%	$	9,839	$	10,063		(2)%
Operating income	$	3,251	$	5,417		(40)%	$	6,573	$	6,894		(5)%

Windows & Windows Live Division (“Windows Division”) develops and markets PC operating systems and related software and online services. The Windows Division offerings consist of multiple editions of the Windows operating system, software and services through Windows Live, and Microsoft PC hardware products.

Windows Division revenue growth is largely correlated to the growth of the PC market worldwide as approximately 75% of total Windows Division revenue comes from pre-installed versions of the Windows operating system purchased by original equipment manufacturers (“OEMs”). The remaining approximately 25% of Windows Division revenue (“other revenue”) is generated by commercial and retail sales of Windows and PC hardware products and online advertising from Windows Live.

Three months ended December 31, 2010 compared with three months ended December 31, 2009

Windows Division revenue decreased primarily due to the prior year launch of Windows 7, including recognition of approximately $1.7 billion of revenue in the prior year related to the Windows 7 Deferral. OEM revenue decreased $1.8 billion or 32%. This decrease was driven by the prior year launch of Windows 7, reflecting a decrease in inventory in our distribution channels, and lower Windows attach rates in China, partially offset by PC market growth. Other revenue decreased $314 million or 20%, driven primarily by the prior year launch of Windows 7. Considering the impact of the Windows 7 launch in the prior year, we estimate Windows Division revenue growth was in line with PC market growth. We estimate total worldwide PC shipments from all sources grew approximately 2% to 4%.

Windows Division operating income decreased primarily as a result of decreased revenue. In addition, sales and marketing expenses increased $22 million or 3% reflecting increased advertising of Windows and Windows Live.

Six months ended December 31, 2010 compared with six months ended December 31, 2009

Windows Division revenue decreased due to the prior year launch of Windows 7, partially offset by PC market growth. OEM revenue decreased $43 million or 1%. This decrease was driven by the prior year launch of Windows 7, reflecting a decrease in inventory in our distribution channels, and lower Windows attach rates in China, partially offset by PC market growth. Other revenue decreased $181 million or 7%, driven primarily by the prior year launch of Windows 7. Considering the impact of the Windows 7 launch in the prior year, we estimate Windows Division revenue growth was in line with PC market growth. We estimate total worldwide PC shipments from all sources grew approximately 6% to 8%.

Windows Division operating income decreased as a result of decreased revenue and higher operating expenses. Sales and marketing expenses increased $46 million or 3% reflecting increased advertising of Windows and Windows Live. Cost of revenue increased $31 million or 3%, primarily driven by higher traffic acquisition costs, partially offset by decreased product and services costs.

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Server and Tools


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


	2010		2009				2010		2009

Revenue	$	4,390	$	3,978		10%	$	8,349	$	7,523		11%
Operating income	$	1,776	$	1,464		21%	$	3,415	$	2,709		26%

Server and Tools develops and markets technology and related services that enable information technology professionals and their systems to be more productive and efficient. Server and Tools product and service offerings include Windows Server, Microsoft SQL Server, Windows Azure, Windows Embedded device platforms and Enterprise Services. Enterprise Services comprise Premier product support services and Microsoft Consulting Services. We also offer developer tools, training and certification. Approximately 50% of Server and Tools revenue comes primarily from multi-year volume licensing agreements, approximately 30% is purchased through transactional volume licensing programs, retail packaged product and licenses sold to OEMs, and the remainder comes from Enterprise Services.

Three months ended December 31, 2010 compared with three months ended December 31, 2009

Server and Tools revenue increased reflecting growth in both product and Enterprise Services. Product revenue increased $343 million or 11%, driven primarily by growth in Windows Server, SQL Server, Enterprise Client Access License (“CAL”) Suites, and developer tools, reflecting continued adoption of Windows platform applications. Enterprise Services revenue grew $69 million or 9%, due to growth in both Premier product support and consulting services.

Server and Tools operating income increased primarily due to revenue growth, offset in part by higher cost of revenue. Cost of revenue increased $62 million or 9%, reflecting higher expenses from providing services and online offerings.

Six months ended December 31, 2010 compared with six months ended December 31, 2009

Server and Tools revenue increased reflecting growth in both product and Enterprise Services. Product revenue increased $690 million or 11%, driven primarily by growth in Windows Server, SQL Server, Enterprise CAL Suites, and Windows Embedded, reflecting continued adoption of Windows platform applications. Enterprise Services revenue grew $136 million or 9%, due to growth in both Premier product support and consulting services.

Server and Tools operating income increased primarily due to revenue growth, offset in part by an increase in cost of revenue. Cost of revenue increased $117 million or 8%, reflecting higher expenses from providing services and online offerings.

Online Services Division


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


	2010			2009					2010			2009

Revenue	$	691		$	579			19%	$	1,218		$	1,067			14%
Operating loss	$	(543	)	$	(463	)		(17)%	$	(1,103	)	$	(940	)		(17)%

Online Services Division (“OSD”) develops and markets information and communication services that help people find what they want online and that help advertisers connect with audiences. OSD offerings include Bing, MSN, and advertiser and publisher tools. Bing and MSN generate revenue through the sale of search and display advertising.

Three months ended December 31, 2010 compared with three months ended December 31, 2009

OSD revenue increased primarily as a result of growth in online advertising revenue. Online advertising revenue grew $117 million or 23% to $632 million, reflecting continued growth in Bing, offset in part by decreased third party advertising revenue.

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OSD operating loss increased due to higher cost of revenue and research and development expenses, offset in part by increased revenue. Cost of revenue grew $110 million driven by costs associated with the Yahoo! search agreement. Research and development expenses grew $68 million or 28%, primarily due to headcount-related expenses associated with the search portion of the business.

Six months ended December 31, 2010 compared with six months ended December 31, 2009

OSD revenue increased primarily as a result of growth in online advertising revenue. Online advertising revenue grew $171 million or 18% to $1.1 billion, reflecting continued growth in Bing, offset in part by decreased third party advertising revenue.

OSD operating loss increased due to higher cost of revenue and research and development expenses, offset in part by increased revenue. Cost of revenue grew $184 million driven by costs associated with the Yahoo! search agreement. Research and development expenses grew $129 million or 28%, primarily due to headcount-related expenses associated with the search portion of the business.

Microsoft Business Division


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


	2010		2009				2010		2009

Revenue	$	6,032	$	4,864		24%	$	11,157	$	9,360		19%
Operating income	$	3,965	$	2,947		35%	$	7,340	$	5,744		28%

Microsoft Business Division (“MBD”) develops and markets software and services designed to increase personal, team, and organization productivity. MBD offerings include the Microsoft Office system (comprising mainly Office, SharePoint, Exchange and Lync), which generates over 90% of MBD revenue, and Microsoft Dynamics business solutions. We evaluate MBD results based upon the nature of the end user in two primary parts: business revenue, which includes Microsoft Office system revenue generated through volume licensing agreements and Microsoft Dynamics revenue; and consumer revenue, which includes revenue from retail packaged product sales and OEM revenue.

Three months ended December 31, 2010 compared with three months ended December 31, 2009

MBD revenue increased primarily reflecting sales of the 2010 Microsoft Office system, which was released primarily during the fourth quarter of fiscal year 2010. Business revenue increased $697 million or 18%, primarily reflecting licensing of the 2010 Microsoft Office system to transactional business customers, growth in multi-year volume licensing revenue, and a 7% increase in Microsoft Dynamics revenue. Consumer revenue increased $471 million or 49% due to sales of the 2010 Microsoft Office system. The growth in consumer revenue includes the recognition of $224 million of revenue associated with the Office Deferral.

MBD operating income increased due mainly to revenue growth, offset in part by higher cost of revenue and research and development costs. Cost of revenue increased $94 million or 30%, primarily driven by higher online costs and costs of providing services. Research and development costs increased $33 million or 7%, primarily as a result of capitalization of certain Microsoft Office system software development costs in the prior year.

Six months ended December 31, 2010 compared with six months ended December 31, 2009

MBD revenue increased primarily reflecting sales of the 2010 Microsoft Office system. Business revenue increased $1.1 billion or 15%, primarily reflecting licensing of the 2010 Microsoft Office system to transactional business customers, growth in multi-year volume licensing revenue, and a 6% increase in Microsoft Dynamics revenue. Consumer revenue increased $697 million or 39% due to sales of the 2010 Microsoft Office system and growth in the PC market. The growth in consumer revenue includes the recognition of $254 million of revenue associated with the Office Deferral.

MBD operating income increased due mainly to revenue growth, offset in part by higher cost of revenue. Cost of revenue increased $174 million or 30%, primarily driven by higher online costs and costs of providing services.

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Entertainment and Devices Division


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


	2010		2009				2010		2009

Revenue	$	3,698	$	2,381		55%	$	5,493	$	3,815		44%
Operating income	$	679	$	365		86%	$	1,067	$	640		67%

Entertainment and Devices Division (“EDD”) develops and markets products and services designed to entertain and connect people. EDD offerings include the Xbox 360 platform (which includes the Xbox 360 gaming and entertainment console, Xbox 360 video games, Xbox LIVE, and Xbox 360 accessories, including Kinect for Xbox 360), Mediaroom (our Internet protocol television software), and Windows Phone. In November 2010, we released Kinect for Xbox 360 and the latest version of Windows Phone. Windows Phone revenue is recognized on a straight-line basis over the estimated economic life of the software.

Three months ended December 31, 2010 compared with three months ended December 31, 2009

EDD revenue increased primarily reflecting higher Xbox 360 platform revenue. Xbox 360 platform revenue grew $1.3 billion or 56%, led by sales of Kinect sensors, increased volumes of Xbox 360 consoles and video games sold, and Xbox LIVE. We shipped 6.3 million Xbox 360 consoles and 8 million Kinect sensors (including those sold with consoles) during the second quarter of fiscal year 2011, compared with 5.2 million Xbox 360 consoles during the second quarter of fiscal year 2010. Xbox 360 video game revenue increased primarily reflecting sales of Kinect game titles.

EDD operating income increased primarily reflecting revenue growth, offset in part by higher operating expenses. Cost of revenue increased $906 million or 61% primarily reflecting higher volumes of Xbox 360 consoles and Kinect sensors sold, and increased royalty costs resulting from increased Xbox LIVE digital content sold. Sales and marketing expenses grew $57 million or 20% primarily reflecting increased Xbox 360 platform marketing activities. Research and development expenses increased $35 million or 15%, primarily reflecting higher headcount-related expenses.

Six months ended December 31, 2010 compared with six months ended December 31, 2009

EDD revenue increased primarily reflecting higher Xbox 360 platform revenue. Xbox 360 platform revenue grew $1.7 billion or 47%, led by sales of Kinect sensors, increased volumes of Xbox 360 consoles and video games sold, and Xbox LIVE. We shipped 9.2 million Xbox 360 consoles and 8 million Kinect sensors (including those sold with consoles) during the first half of fiscal year 2011, compared with 7.3 million Xbox 360 consoles during the first half of fiscal year 2010. Xbox 360 video game revenue increased primarily reflecting sales of Halo Reach and Kinect game titles.

EDD operating income increased primarily reflecting revenue growth, offset in part by higher operating expenses. Cost of revenue increased $1.1 billion or 46% primarily reflecting higher volumes of Xbox 360 consoles and Kinect sensors sold. Research and development expenses increased $103 million or 23%, primarily reflecting higher headcount-related expenses. Sales and marketing expenses grew $85 million or 20% primarily reflecting increased Xbox 360 platform marketing activities.

Corporate-Level Activity


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


	2010			2009					2010			2009

Corporate-level activity	$	(963	)	$	(1,217	)		21%	$	(2,011	)	$	(2,052	)		2%

Certain corporate-level activity is not allocated to our segments, including costs of: broad-based sales and marketing; product support services; human resources; legal; finance; information technology; corporate development and procurement activities; research and development; and legal settlements and contingencies. For the three months ended December 31, 2010, corporate-level expenses decreased due mainly to a $225 million decrease in legal

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charges and a 2% decrease in headcount-related expenses. For the six months ended December 31, 2010, corporate-level expenses decreased due mainly to a $112 million decrease in legal charges, offset in part by a 2% increase in headcount-related expenses.

OPERATING EXPENSES

Cost of Revenue


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


	2010			2009					2010			2009

Cost of revenue	$	4,833		$	3,628			33%	$	7,972		$	6,470			23%
As a percent of revenue		24	%		19	%		5ppt		22	%		20	%		2ppt

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 include software on PCs sold by OEMs, to drive traffic to our Web sites and to 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. Cost of revenue increased primarily due to increased volumes of Xbox 360 consoles and accessories sold and higher costs associated with our online offerings.

Research and Development


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


	2010			2009					2010			2009

Research and development	$	2,185		$	2,079			5%	$	4,381		$	4,144			6%
As a percent of revenue		11	%		11	%		0ppt		12	%		13	%		(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, and the amortization of purchased software code and services content. The increase in research and development expenses was primarily driven by a 4% increase in headcount-related expenses, the capitalization of certain software development costs in the prior year, and higher third-party development and programming costs, partially offset by a decrease in localization and lab costs.

Sales and Marketing


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


	2010			2009					2010			2009

Sales and marketing	$	3,825		$	3,619			6%	$	6,631		$	6,409			3%
As a percent of revenue		19	%		19	%		0ppt		18	%		20	%		(2)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 the costs of advertising, promotions, trade shows, seminars, and other programs. Sales and marketing expenses increased primarily as a result of increased advertising and marketing of the Xbox 360 platform, Windows Phone, and Windows and Windows Live, and a 2% increase in headcount-related expenses.

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General and Administrative


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


	2010			2009					2010			2009

General and administrative	$	945		$	1,183			(20)%	$	1,883		$	1,924			(2)%
As a percent of revenue		5	%		6	%		(1)ppt		5	%		6	%		(1)ppt

General and administrative expenses include payroll, employee benefits, stock-based compensation expense, employee severance, 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 decreased primarily due to a reduction in legal charges, as discussed under Corporate-Level Activity above, and employee severance, partially offset by an increase in headcount-related expenses.

OTHER INCOME AND INCOME TAXES

Other Income

The components of other income were as follows:


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


	2010			2009			2010			2009

Dividends and interest income	$	205		$	197		$	415		$	400
Interest expense		(72	)		(38	)		(117	)		(76	)
Net recognized gains on investments		118			92			152			162
Net gains on derivatives		108			96			103			92
Net gains (losses) on foreign currency remeasurements		(27	)		(23	)		(69	)		32
Other		0			46			(38	)		43

Total	$	332		$	370		$	446		$	653

Dividends and interest income increased slightly due to higher average portfolio investment balances, offset in part by lower yields on our fixed-income investments. Interest expense increased due to our increased issuance of debt. Net recognized gains on investments increased in the three months ended December 31, 2010 due primarily to higher gains on sales of equity securities and were relatively consistent in the six months ended December 31, 2010 as compared to the prior period. Net gains on derivatives increased in both the three months and six months ended December 31, 2010 due primarily to higher gains on commodity and interest rate derivatives offset in part by higher losses on currency contracts used to hedge foreign currency revenues. Year-over-year changes in foreign currency remeasurements were primarily due to currency movements net of our hedging activities. Other includes a gain on the divestiture of Razorfish in the prior year periods.

Income Taxes

Our effective tax rates were approximately 22% and 25% for the three months ended December 31, 2010 and 2009, respectively, as compared to 23% and 25% for the six months ended December 31, 2010 and 2009, respectively. The reduction in the tax rate was due to the higher mix of earnings taxed at lower rates in foreign jurisdictions and from the retroactive extension of the research and development tax credit in the United States.

FINANCIAL CONDITION

Cash, Cash Equivalents, and Investments

Cash, cash equivalents, and short-term investments totaled $41.3 billion as of December 31, 2010, compared with $36.8 billion as of June 30, 2010. Our short-term investments are primarily to facilitate liquidity and for capital preservation. They consist predominantly of investment grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantly U.S. dollar-denominated securities, but also include foreign currency-denominated securities in order to diversify risk. Equity and other investments were $10.0 billion as of December 31, 2010, compared with $7.8 billion as of June 30, 2010.

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While we own certain mortgage-backed and asset-backed fixed-income securities, our portfolio as of December 31, 2010 does not contain direct exposure to subprime mortgages or structured vehicles that derive their value from subprime collateral. The majority of our 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. Our securities lending payable balance was $1.4 billion as of December 31, 2010. Our average and maximum securities lending payable balances for the three months ended December 31, 2010 were $2.1 billion and $3.3 billion, respectively. Our average and maximum securities lending payable balances for the six months ended December 31, 2010 were $1.9 billion and $3.3 billion, respectively. Intra-quarter variances in the amount of securities loaned are mainly due to fluctuations in the demand for the securities.

Valuation

In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our financial instruments. This pricing methodology applies to our Level 1 investments, such as exchange-traded mutual funds, domestic and international equities, and U.S. treasuries. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments such as corporate notes and bonds, foreign government bonds, mortgage-backed securities, and agency securities. Level 3 investments are valued using internally developed models with unobservable inputs. Assets and liabilities measured using unobservable inputs are an immaterial portion of our portfolio.

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

Debt

Short-term Debt

During the three months ended December 31, 2010, we repaid $1.0 billion of commercial paper, leaving zero outstanding.

Long-term Debt

Notes

As of December 31, 2010, we had issued and outstanding $8.5 billion of debt securities as follows: $1.0 billion aggregate principal amount of 0.875% notes due 2013, $2.0 billion aggregate principal amount of 2.95% notes due 2014, $1.75 billion aggregate principal amount of 1.625% notes due 2015, $1.0 billion aggregate principal amount of

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4.20% notes due 2019, $1.0 billion aggregate principal amount of 3.0% notes due 2020, $750 million aggregate principal amount of 5.20% notes due 2039, and $1.0 billion aggregate principal amount of 4.5% notes due 2040, (collectively “the Notes”). The Notes are senior unsecured obligations and rank equally with our other unsecured and unsubordinated debt outstanding.

Convertible Debt

Unearned Revenue

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