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MICROSOFT CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) Note About Forward-Looking Statements Certain statements in this report, other than purely historical information, including estimates, projections, statements relating to our business plans, objectives, and expected operating results, and the assumptions upon which those statements are based, are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may appear throughout this report, including without limitation, the following sections: "Management's Discussion and Analysis," and "Risk Factors." These forward-looking statements generally are identified by the words "believe," "project," "expect," "anticipate," "estimate," "intend," "strategy," "future," "opportunity," "plan," "may," "should," "will," "would," "will be," "will continue," "will likely result," and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially from the forward-looking statements. A detailed discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section titled "Risk Factors" (Part II, Item 1A of this Form 10-Q). We undertake no obligation to update or revise publicly any forward-looking statements, whether because of new information, future events, or otherwise. OVERVIEW The following management's discussion and analysis ("MD&A") is intended to help the reader understand the results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our Annual Report on Form 10-K for the year ended June 30, 2011 and our financial statements and accompanying Notes to Financial Statements. Microsoft is a technology leader focused on helping people and businesses throughout the world realize their full potential. We create technology that transforms the way people work, play, and communicate across a wide range of computing devices. We generate revenue by developing, licensing, and supporting a wide range of software products and services, by designing and selling hardware, and by delivering relevant online advertising to a global customer audience. Our most significant expenses are related to compensating employees, designing, manufacturing, marketing and selling our products and services, and income taxes. Industry Trends Our industry is dynamic and highly competitive, with frequent changes in both technologies and business models. Each industry shift is an opportunity to conceive new products, new technologies, or new ideas which can further transform the industry and our business. At Microsoft, we push the boundaries of what is possible through a broad set of research and technology innovations that seek to anticipate the changing demands of customers, industry trends, and competitive forces. Key Opportunities and Investments Based on our assessment of key technology trends and our broad focus on long-term research and development of new products and services, we see significant opportunities to drive future growth. Smart connected devices The price per unit of processing, storage, and networks continues to decline while at the same time devices increase in capability. As a result, the capabilities and accessibility of PCs, mobile, and other devices powered by rich software platforms and applications continue to grow. At the same time, the information and services people use increasingly span multiple devices. User experiences will be transformed by the adoption of cloud computing when brought together with the richness of smart, connected devices. Microsoft is delivering experiences that seamlessly connect PCs and mobile and other devices through the cloud. We are devoting significant resources to consumer cloud offerings like Bing, Windows Live, and Xbox LIVE. Our software and hardware platform investments can be seen in products like Kinect, Windows, Windows Azure, Windows Phone, Windows Server, and Xbox. 28 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Cloud computing transforming the data center and information technology Cloud-based solutions provide customers with software, services and content over the Internet by way of shared computing resources located in centralized data centers. Computing is undergoing a long-term shift from client/server to the cloud, a shift similar in importance and impact to the transition from mainframe to client/server. The shift to the cloud is driven by three important economies of scale: larger data centers can deploy computational resources at significantly lower cost per unit than smaller ones; larger data centers can coordinate and aggregate diverse customer, geographic, and application demand patterns which can improve the utilization of computing, storage, and network resources; and multi-tenancy lowers application maintenance labor costs for large public clouds. As a result of the improved economics, the cloud offers unique levels of elasticity and agility that will enable new solutions and applications. For businesses of all sizes, the cloud creates the opportunity to focus more on innovation while leaving non-differentiating activities to reliable and cost-effective providers. For many businesses, the first step in achieving cloud economics is the adoption of virtualization in their data center. We are devoting significant resources to developing cloud infrastructure, platforms, and applications including offerings such as Microsoft Dynamics Online, Microsoft SQL Azure, Office 365, Windows Azure, Windows Intune, and Windows Server. Entertainment The evolution of hardware, software, services, and the cloud are enhancing the delivery and quality of unified entertainment experiences across many devices. These rich media experiences include games, movies, music, television, and social interactions with family, friends, and colleagues. At Microsoft, our approach is to simplify and increase the accessibility of these entertainment experiences to broaden market penetration of our software and services. We invest significant resources to develop or partner to develop hardware, software, and content that is used in products and services such as Windows Phone, Xbox, Xbox LIVE, and Skype. Search Over the last two decades, web content and social connections have increased dramatically as people spend more time online, while discoverability and accessibility has been transforming from direct navigation and document links. There is significant opportunity to deliver differentiated products that helps users make better decisions and complete tasks more simply when using PC, mobile, and other devices. Our approach is to use machine learning to try to understand user intent, and differentiate our product by focusing on the integration of visual, social, and other elements which simplifies people's interaction with the Internet. We invest significant resources in Bing, SharePoint, Windows, Windows Phone, and Xbox LIVE. Communications and productivity Personal and business productivity has been transformed by the ubiquity of computing and software tools. Over the last decade, Microsoft redefined software productivity beyond the rich Office client on the PC. Productivity scenarios now encompass unified communications, business intelligence, collaboration, content management, and relationship management, which are increasingly powered by server-side applications. These server applications can be hosted by the customer, a partner, or by Microsoft in the cloud. There are significant opportunities to provide productivity and communication scenarios across PCs, mobile devices, and other devices that connect to services. We invest significant resources in Dynamics, Exchange, Lync, Skype, Office, Office 365, SharePoint, and Windows Live. Economic Conditions, Challenges and Risks As discussed above, our industry is dynamic and highly competitive. We must anticipate changes in technology and business models. Our model for growth is based on our ability to initiate and embrace disruptive technology trends, to enter new markets, both in terms of geographies and product areas, and to drive broad adoption of the products and services we develop and market. At Microsoft, we prioritize our investments among the highest long-term growth opportunities. These investments require significant resources and are multi-year in nature. The products and services we bring to market can be built internally, brought to market as part of a partnership or alliance, or through acquisition. Our success is highly dependent on our ability to attract and retain qualified employees. We rely on hiring from a mix of university and industry talent worldwide. Microsoft competes for talented individuals worldwide by offering broad customer reach, scale in resources, and competitive compensation. 29 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Demand for our software, services, and hardware has a strong correlation to global macroeconomic factors. The current macroeconomic factors remain dynamic. See a discussion of these factors and other risks under Risk Factors (Part II, Item 1A. of this Form 10-Q). Seasonality Our revenue historically has fluctuated quarterly and has generally been the highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers. Our Entertainment and Devices Division is particularly seasonal as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Typically, the Entertainment and Devices Division has generated approximately 40% of its yearly segment revenue in our second fiscal quarter. In addition, quarterly revenue may be impacted by the deferral of revenue. See the discussions below regarding 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"). RESULTS OF OPERATIONS Summary (In millions, except percentages and per share Three Months Ended Percentage Six Months Ended Percentage amounts) December 31, Change December 31, Change------------------------------------------------------------------------------------------------------------------------ - 2011 2010 2011 2010 Revenue $ 20,885 $ 19,953 5% $ 38,257 $ 36,148 6% Operating income $ 7,994 $ 8,165 (2)% $ 15,197 $ 15,281 (1)% Diluted earnings per share $ 0.78 $ 0.77 1% $ 1.46 $ 1.39 5%------------------------------------------------------------------------------------------------------------------------ - Three months ended December 31, 2011 compared with three months ended December 31, 2010 Revenue increased primarily due to strong sales of Server and Tools products, the Xbox 360 entertainment platform, and the 2010 Microsoft Office system, offset in part by a decline in sales of PCs to consumers. Revenue for the three months ended December 31, 2011 also included Skype revenue from the date of acquisition and a favorable foreign currency impact of $225 million. Operating income decreased reflecting higher operating expenses, offset in part by revenue growth. Key changes in operating expenses were: • Cost of revenue increased $805 million or 17%, primarily reflecting higher volumes of Xbox 360 consoles sold and increased Xbox royalty costs, higher costs associated with providing Server and Tools products and services, payments made to Nokia related to joint strategic initiatives, and increased costs associated with our online offerings, including traffic acquisition costs. • Research and development expenses increased $186 million or 9%, due mainly to higher headcount-related expenses. • General and administrative expenses increased $175 million or 19%, due mainly to Puerto Rican excise taxes, higher headcount-related expenses, and increased legal costs. Headcount-related expenses increased across the company reflecting annual increases in pay and bonuses, changes in our employee compensation program, and a 4% increase in headcount from December 31, 2010. Diluted earnings per share increased reflecting increased net income and the repurchase of 174 million shares during the 12 months ended December 31, 2011. Six months ended December 31, 2011 compared with six months ended December 31, 2010 Revenue increased primarily due to strong sales of Server and Tools products, the Xbox 360 entertainment platform, and the 2010 Microsoft Office system, offset in part by a decline in sales of PCs to consumers. Revenue for the six months ended December 31, 2011 also included Skype revenue from the date of acquisition and a favorable foreign currency impact of $635 million. 30 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Operating income decreased slightly reflecting higher operating expenses, offset in part by revenue growth. Key changes in operating expenses were: • Cost of revenue increased $1.4 billion or 18%, primarily due to higher Xbox royalty costs, higher costs associated with providing Server and Tools products and services, increased costs associated with our online offerings, including traffic acquisition costs, and payments made to Nokia related to joint strategic initiatives. • General and administrative expenses increased $400 million or 21%, due mainly to Puerto Rican excise taxes, higher headcount-related expenses, and increased legal costs. • Research and development expenses increased $319 million or 7%, due mainly to higher headcount-related expenses. Headcount-related expenses increased across the company reflecting annual increases in pay and bonuses, changes in our employee compensation program, and a 4% increase in headcount from December 31, 2010. Diluted earnings per share increased reflecting increased net income and the repurchase of 174 million shares during the 12 months ended December 31, 2011. SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS) The revenue and operating income (loss) amounts in this section are presented on a basis consistent with accounting principles generally accepted in the U.S. ("U.S. GAAP") and include certain reconciling items attributable to each of the segments. Segment information appearing in Note 17 - Segment Information of the Notes to Financial Statements (Part I, Item I of this Form 10-Q) is presented on a basis consistent with our current internal management reporting. Certain corporate-level activity has been excluded from segment operating results and is analyzed separately. We have recast certain prior period amounts within this MD&A to conform to the way we internally managed and monitored segment performance during the current fiscal year, including moving Forefront Protection for Office, an anti-malware solution, from Server and Tools to the Microsoft Business Division. Windows & Windows Live Division Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change ---------------------------------------------------------------------------------------------------------------------------- - 2011 2010 2011 2010 Revenue $ 4,736 $ 5,056 (6)% $ 9,604 $ 9,843 (2)% Operating income $ 2,850 $ 3,214 (11)% $ 6,101 $ 6,502 (6)%---------------------------------------------------------------------------------------------------------------------------- - Windows & Windows Live Division ("Windows Division") develops and markets PC operating systems, related software and online services, and PC hardware products. This collection of software, hardware, and services is designed to simplify everyday tasks through efficient browsing capabilities and seamless operations across the user's hardware and software. 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 is largely correlated to the PC market worldwide, as approximately 75% of total Windows Division revenue comes from Windows operating system software purchased by original equipment manufacturers ("OEMs") which they pre-install on equipment they sell. The remaining approximately 25% of Windows Division 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, 2011 compared with three months ended December 31, 2010 Windows Division revenue reflected relative performance in PC market segments. We estimate that sales of PCs to businesses grew approximately 2% and sales of PCs to consumers declined approximately 6%. Excluding a decline in sales of netbooks, we estimate that sales of PCs to consumers grew approximately 2%. Taken together, the total PC market decreased an estimated 2% to 4%, including the impact of supply chain issues from the Thailand floods. Windows Division revenue was also negatively impacted by a reduction in inventory levels within our distribution channels as well as by the effect of higher growth in emerging markets, where average selling prices are lower, relative to developed markets, and by lower recognition of previously deferred Windows XP revenue. 31 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Windows Division operating income decreased primarily because of lower revenue and higher research and development expenses. Research and development expenses increased due mainly to an increase in headcount-related costs and product development costs associated with the next version of the Windows operating system. Six months ended December 31, 2011 compared with six months ended December 31, 2010 Windows Division revenue reflected relative performance in PC market segments. We estimate that sales of PCs to businesses grew approximately 5% and sales of PCs to consumers declined approximately 2%. Excluding a decline in sales of netbooks, we estimate that sales of PCs to consumers grew approximately 5%. Taken together, the total PC market remained flat. Windows Division revenue was negatively impacted by higher growth in emerging markets, where average selling prices are lower, relative to developed markets, and by lower recognition of previously deferred Windows XP revenue. Windows Division operating income decreased because of lower revenue and higher operating expenses, primarily research and development expenses associated with the next version of the Windows operating system. Server and Tools Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change ----------------------------------------------------------------------------------------------------------------------------- - 2011 2010 2011 2010 Revenue $ 4,772 $ 4,288 11% $ 9,022 $ 8,149 11% Operating income $ 1,996 $ 1,711 17% $ 3,593 $ 3,248 11%----------------------------------------------------------------------------------------------------------------------------- - Server and Tools develops and markets technology and related services that enable information technology professionals and their systems to be more productive and efficient. Server and Tools product and service offerings include Windows Server, Microsoft SQL Server, Windows Azure, Visual Studio, System Center products, Windows Embedded device platforms, and Enterprise Services. Enterprise Services comprise Premier product support services and Microsoft Consulting Services. We also offer developer tools, training and certification. Approximately 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, 2011 compared with three months ended December 31, 2010 Server and Tools revenue increased reflecting growth in both product sales and Enterprise Services. Product revenue increased $328 million or 10%, driven primarily by growth in SQL Server, Windows Server, Enterprise CAL Suites, and System Center, reflecting continued adoption of Windows platform applications. Enterprise Services revenue grew in both Premier product support and consulting services. Server and Tools operating income increased primarily due to revenue growth, offset in part by higher costs of providing products and services. Six months ended December 31, 2011 compared with six months ended December 31, 2010 Server and Tools revenue increased $873 million or 11%, reflecting growth in SQL Server, Windows Server, Enterprise CAL Suites, System Center, and Enterprise Services. Server and Tools revenue for the six months ended December 31, 2011 included a favorable foreign currency impact of $170 million. 32 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Server and Tools operating income increased due to revenue growth, offset in part by higher costs of providing products and services. Online Services Division Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change --------------------------------------------------------------------------------------------------------------------------------- - 2011 2010 2011 2010 Revenue $ 784 $ 713 10% $ 1,425 $ 1,260 13% Operating loss $ (458 ) $ (559 ) 18% $ (971 ) $ (1,132 ) 14%--------------------------------------------------------------------------------------------------------------------------------- - Online Services Division ("OSD") develops and markets information and content designed to help people simplify tasks and make more informed decisions online, and that help advertisers connect with audiences. OSD offerings include Bing, MSN, adCenter, and advertiser tools. Bing and MSN generate revenue through the sale of search and display advertising. Search and display advertising accounts for nearly all of OSD's annual revenue. Three months ended December 31, 2011 compared with three months ended December 31, 2010 OSD revenue increased primarily as a result of growth in online advertising revenue. Online advertising revenue grew $81 million or 13% to $713 million, reflecting continued growth in search and display advertising revenue, offset in part by decreased third party display advertising revenue. As of December 31, 2011, according to third-party sources, Bing organic U.S. market share grew over 25% from December 31, 2010 to approximately 15%. Bing-powered U.S. market share, including Yahoo! properties, grew over 9% during this same period to approximately 27%. OSD operating loss decreased due primarily to higher revenue and lower sales and marketing expenses, offset in part by increased cost of revenue. Six months ended December 31, 2011 compared with six months ended December 31, 2010 OSD revenue increased primarily as a result of growth in online advertising revenue. Online advertising revenue grew $181 million or 16% to $1.3 billion, reflecting continued growth in search and display advertising revenue, offset in part by decreased third party display advertising revenue. As of December 31, 2011, according to third-party sources, Bing organic U.S. market share grew over 25% from December 31, 2010 to approximately 15%. Bing-powered U.S. market share, including Yahoo! properties, grew over 9% during this same period to approximately 27%. OSD operating loss decreased due primarily to higher revenue and lower sales and marketing expenses, offset in part by increased cost of revenue. Microsoft Business Division Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change ----------------------------------------------------------------------------------------------------------------------------- - 2011 2010 2011 2010 Revenue $ 6,279 $ 6,110 3% $ 11,886 $ 11,312 5% Operating income $ 4,152 $ 4,087 2% $ 7,839 $ 7,570 4%----------------------------------------------------------------------------------------------------------------------------- - 33 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Microsoft Business Division ("MBD") develops and markets software and online services designed to increase personal, team, and organization productivity. MBD offerings include the Microsoft Office system (comprising mainly Office, SharePoint, Exchange, Lync, and Office 365), which generates over 90% of MBD revenue, and Microsoft Dynamics business solutions. We evaluate MBD results based upon the nature of the end user in two primary parts: business revenue, which includes Microsoft Office system revenue generated through volume licensing agreements and Microsoft Dynamics revenue; and consumer revenue, which includes revenue from retail packaged product sales and OEM revenue. Three months ended December 31, 2011 compared with three months ended December 31, 2010 MBD revenue increased primarily reflecting sales of the 2010 Microsoft Office system. Business revenue increased $420 million or 9%, primarily reflecting growth in multi-year volume licensing revenue, licensing of the 2010 Microsoft Office system to transactional business customers, and an 11% increase in Microsoft Dynamics revenue. Consumer revenue decreased $251 million or 17% due mainly to the recognition of $224 million of revenue in the prior year associated with the Office Deferral. Excluding the impact associated with the Office Deferral, consumer revenue decreased $27 million or 2% due to decreased sales of the 2010 Microsoft Office system. MBD revenue for the three months ended December 31, 2011 included a favorable foreign currency impact of $131 million. MBD operating income increased due to revenue growth, offset in part by higher operating expenses. Cost of revenue increased, primarily driven by higher online operation and support costs. Six months ended December 31, 2011 compared with six months ended December 31, 2010 MBD revenue increased primarily reflecting sales of the 2010 Microsoft Office system. Business revenue increased $742 million or 8%, primarily reflecting growth in multi-year volume licensing revenue, licensing of the 2010 Microsoft Office system to transactional business customers, and a 14% increase in Microsoft Dynamics revenue. Consumer revenue decreased $168 million or 7% due to the recognition of $254 million of revenue in the prior year associated with the Office Deferral. Excluding the impact associated with the Office Deferral, consumer revenue increased $86 million or 4% driven by increased sales of the 2010 Microsoft Office system. MBD revenue for the six months ended December 31, 2011 included a favorable foreign currency impact of $337 million. MBD operating income increased due to revenue growth, offset in part by higher operating expenses. Cost of revenue increased, primarily driven by higher online operation and support costs. Entertainment and Devices Division Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change ----------------------------------------------------------------------------------------------------------------------------- - 2011 2010 2011 2010 Revenue $ 4,237 $ 3,698 15% $ 6,198 $ 5,493 13% Operating income $ 528 $ 666 (21)% $ 877 $ 1,050 (16)%----------------------------------------------------------------------------------------------------------------------------- - Entertainment and Devices Division ("EDD") develops and markets products and services designed to entertain and connect people. EDD offerings include the Xbox 360 entertainment platform (which includes the Xbox 360 gaming and entertainment console, Kinect for Xbox 360, Xbox 360 video games, Xbox LIVE, and Xbox 360 accessories), Mediaroom (our Internet protocol television software), Skype, and Windows Phone, including related patent licensing revenue. In November 2010, we released Kinect for Xbox 360. We acquired Skype on October 13, 2011. Three months ended December 31, 2011 compared with three months ended December 31, 2010 EDD revenue increased primarily reflecting higher Xbox 360 platform revenue as well as Skype revenue from the date of acquisition. Xbox 360 platform revenue grew $322 million or 9%, led by increased volumes of Xbox 360 consoles sold and 34 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 higher Xbox LIVE revenue, offset in part by lower volumes of standalone Kinect sensors sold. We shipped 8.2 million Xbox 360 consoles during the second quarter of fiscal year 2012, compared with 6.3 million Xbox 360 consoles during the second quarter of fiscal year 2011. EDD operating income decreased reflecting higher operating expenses, offset in part by revenue growth. Cost of revenue grew $461 million or 19% primarily due to higher volumes of Xbox 360 consoles sold, payments made to Nokia related to joint strategic initiatives, Skype cost of revenue, and higher royalty costs resulting from an increase in Xbox LIVE digital marketplace third-party content sold. Research and development expenses increased $101 million or 37%, primarily reflecting higher headcount-related expenses, including Skype headcount. Sales and marketing expenses increased $94 million or 27%, primarily reflecting higher headcount-related expenses, including Skype headcount, and amortization of acquired Skype intangibles. Six months ended December 31, 2011 compared with six months ended December 31, 2010 EDD revenue increased primarily reflecting higher Xbox 360 platform revenue as well as Skype revenue from the date of acquisition. Xbox 360 platform revenue grew $430 million or 8%, led by increased volumes of Xbox 360 consoles sold and higher Xbox LIVE revenue, offset in part by lower volumes of standalone Kinect sensors sold and decreased video game revenue. We shipped 10.5 million Xbox 360 consoles during the first half of fiscal year 2012, compared with 9.2 million Xbox 360 consoles during the first half of fiscal year 2011. Video game revenue decreased due to strong sales of Halo Reach in the prior year. EDD operating income decreased reflecting higher operating expenses, offset in part by revenue growth. Cost of revenue grew $633 million or 19% primarily due to higher royalty costs resulting from an increase in Xbox LIVE digital marketplace third-party content sold and sales of Gears of War 3 and due to payments made to Nokia related to joint strategic initiatives. Research and development expenses increased $125 million or 22%, primarily reflecting higher headcount-related expenses, including Skype headcount. Sales and marketing expenses increased $100 million or 19%, primarily reflecting higher headcount-related expenses, including Skype headcount, and amortization of acquired Skype intangibles. Corporate-Level Activity Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change ----------------------------------------------------------------------------------------------------------------------------------- - 2011 2010 2011 2010 Corporate-level activity $ (1,074 ) $ (954 ) (13)% $ (2,242 ) $ (1,957 ) (15)%----------------------------------------------------------------------------------------------------------------------------------- - 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. Corporate-level expenses increased due mainly to Puerto Rican excise taxes, higher headcount-related expenses, and increased legal costs. OPERATING EXPENSES Cost of Revenue Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change ------------------------------------------------------------------------------------------------------------------------------- - 2011 2010 2011 2010 Cost of revenue $ 5,638 $ 4,833 17% $ 9,415 $ 7,972 18% As a percent of revenue 27 % 24 % 3ppt 25 % 22 % 3ppt------------------------------------------------------------------------------------------------------------------------------- - 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 including royalties; warranty costs; inventory valuation adjustments; costs associated with the delivery of consulting services; and the amortization of capitalized research and development costs. 35 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Cost of revenue increased reflecting higher headcount-related costs, increased traffic acquisition costs, including payments made to Nokia related to joint strategic initiatives, higher Xbox 360 entertainment platform royalty costs, and higher volumes of Xbox 360 consoles sold. Headcount-related expenses increased 19% and 22% for the three and six months ended December 31, 2011, respectively, primarily related to increased Enterprise Services headcount. Research and Development Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change ------------------------------------------------------------------------------------------------------------------------------- - 2011 2010 2011 2010 Research and development $ 2,371 $ 2,185 9% $ 4,700 $ 4,381 7% As a percent of revenue 11 % 11 % 0ppt 12 % 12 % 0ppt------------------------------------------------------------------------------------------------------------------------------- - 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. Research and development expenses increased, primarily reflecting a 9% increase in headcount-related expenses during the three and six months ended December 31, 2011. Sales and Marketing Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change --------------------------------------------------------------------------------------------------------------------------------- - 2011 2010 2011 2010 Sales and marketing $ 3,762 $ 3,825 (2)% $ 6,662 $ 6,631 1% As a percent of revenue 18 % 19 % (1)ppt 17 % 18 % (1)ppt--------------------------------------------------------------------------------------------------------------------------------- - Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel and the costs of advertising, promotions, trade shows, seminars, and other programs. For the three months ended December 31, 2011, sales and marketing expenses decreased primarily due to decreased marketing spend. For the six months ended December 31, 2011, sales and marketing expenses increased primarily reflecting a 7% increase in headcount-related expenses, offset in part by decreased marketing spend. General and Administrative Three Months Ended Percentage Six Months Ended Percentage (In millions, except percentages) December 31, Change December 31, Change ------------------------------------------------------------------------------------------------------------------------------- - 2011 2010 2011 2010 General and administrative $ 1,120 $ 945 19% $ 2,283 $ 1,883 21% As a percent of revenue 5 % 5 % 0ppt 6 % 5 % 1ppt------------------------------------------------------------------------------------------------------------------------------- - General and administrative expenses include payroll, employee benefits, stock-based compensation expense, severance expense, and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative personnel, certain taxes, and legal and other administrative fees. General and administrative expenses increased primarily due to Puerto Rican excise taxes, higher headcount-related expenses, and increased legal costs. Headcount-related expenses increased 15% and 12% for the three and six months ended December 31, 2011, respectively. 36 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 OTHER INCOME AND INCOME TAXES Other Income The components of other income were as follows: Three Months Ended Six Months Ended (In millions) December 31, December 31,------------------------------------------------------------------------------------------------------ -- 2011 2010 2011 2010 Dividends and interest income $ 182 $ 205 $ 393 $ 415 Interest expense (95 ) (72 ) (189 ) (117 ) Net recognized gains on investments 315 118 318 152 Net gains (losses) on derivatives (203 ) 108 (176 ) 103 Net losses on foreign currency remeasurements (4 ) (27 ) (44 ) (69 ) Other 50 0 46 (38 ) --------------------------------------------------------- -- - ------- -- - ------- -- - ------- -- Total $ 245 $ 332 $ 348 $ 446 - ------- -- - ------- -- - ------- -- - ------- -- 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. Gains and losses from changes in fair values of derivatives that are not designated as hedges are recognized in other income (expense). These are generally offset by unrealized gains and losses in the underlying securities in the investment portfolio and are recorded as a component of other comprehensive income. Dividends and interest income decreased slightly due to lower yields on our fixed-income investments, offset in part by higher average portfolio investment balances. Interest expense increased due to our increased issuance of debt. Net recognized gains on investments increased due primarily to higher gains on sales of equity securities, offset in part due to higher other-than-temporary impairments. Other-than-temporary impairments were $107 million and $152 million during the three and six months ended December 31, 2011, respectively, compared to $18 million and $27 million during the three and six months ended December 31, 2010. Net losses on derivatives increased for the three months ended December 31, 2011 due primarily to higher losses on currency contracts used to hedge foreign currency revenue, higher losses on equity derivatives, and lower gains on commodity derivatives. Net losses on derivatives also increased for the six months ended December 31, 2011 due primarily to losses on commodity and equity derivatives in the current period as compared to gains in the comparable period. Changes in foreign currency remeasurements were primarily due to currency movements net of our hedging activities. Income Taxes Our effective tax rates were approximately 20% and 22% for the three months ended December 31, 2011 and 2010, respectively, and 20% and 23% for the six months ended December 31, 2011 and 2010, respectively. Our effective tax rate was lower than the U.S. federal statutory rate and our prior year effective rates primarily due to a higher mix of earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico, which are subject to lower income tax rates. Changes in the mix of income before income taxes between the U.S. and foreign countries resulted primarily from changes in the geographic distribution of and changes in consumer demand for our products and services. As discussed above, Windows Division operating income declined $401 million for the six months ended December 31, 2011, while MBD and Server and Tools operating income increased $269 million and $345 million, respectively, during this same period. We supply Windows, our primary Windows Division product, to customers through our U.S. regional operating center, while we supply the Microsoft Office System, our primary MBD product, and our Server and Tools products to customers through our foreign regional operations centers. Tax contingencies and other tax liabilities were $7.7 billion and $7.4 billion as of December 31, 2011 and June 30, 2011, respectively, and are included in other long-term liabilities. While we settled a portion of the I.R.S. audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, we remain under audit for these years. During the fourth quarter of fiscal year 2011, the I.R.S. completed its examination and issued a Revenue Agent's Report ("RAR") for the remaining unresolved items. We do not agree with the adjustments in the RAR, and we have filed a protest to initiate the 37 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 administrative appeals process. The proposed adjustments are primarily related to transfer pricing and could have a significant impact on our financial statements if not resolved favorably; however, we believe our existing reserves are adequate. We do not believe it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months, as we do not believe the appeals process will be concluded within the next 12 months. We also continue to be subject to examination by the I.R.S. for tax years 2007 to 2011. FINANCIAL CONDITION Cash, Cash Equivalents, and Investments Cash, cash equivalents, and short-term investments totaled $51.7 billion as of December 31, 2011, compared with $52.8 billion as of June 30, 2011. Equity and other investments were $7.6 billion as of December 31, 2011 compared to $10.9 billion as of June 30, 2011. Our short-term investments are primarily to facilitate liquidity and for capital preservation. They consist predominantly of highly liquid investment grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantly U.S. dollar-denominated securities, but also include foreign currency-denominated securities in order to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are managed to achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid investment-grade fixed-income securities. While we own certain mortgage-backed and asset-backed fixed-income securities, our portfolio as of December 31, 2011 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 routinely monitor our financial exposure to both sovereign and non-sovereign borrowers and counterparties. Our gross exposures to our customers and investments in Portugal, Italy, Ireland, Greece, and Spain are individually and collectively not material. Of the cash, cash equivalents, and short-term investments at December 31, 2011, approximately $46 billion was held by our foreign subsidiaries and were subject to material repatriation tax effects. The amount of cash and investments held by foreign subsidiaries subject to other restrictions on the free flow of funds (primarily currency and other local regulatory) was approximately $410 million. As of December 31, 2011, approximately 65% of the short-term investments held by our foreign subsidiaries were invested in U.S. government and agency securities, approximately 16% were invested in corporate notes and bonds of U.S. companies, and 4% were invested in U.S. mortgage-backed securities, all of which are denominated in U.S. dollars. Securities lending We lend certain fixed-income and equity securities to increase investment returns. The loaned securities continue to be carried as investments on our balance sheet. Cash and/or security interests are received as collateral for the loaned securities with the amount determined based upon the underlying security lent and the creditworthiness of the borrower. Cash received is recorded as an asset with a corresponding liability. Our securities lending payable balance was $849 million as of December 31, 2011. Our average and maximum securities lending payable balances for the three months ended December 31, 2011 were $1.3 billion and $1.4 billion, respectively. Our average and maximum securities lending payable balances for the six months ended December 31, 2011 were $1.2 billion and $1.4 billion, respectively. Intra-quarter variances in the amount of securities loaned are mainly due to fluctuations in the demand for the securities. Valuation In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our financial instruments. This pricing methodology applies to our Level 1 investments, such as exchange-traded mutual funds, domestic and international equities, and U.S. treasuries. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments such as corporate notes and bonds, foreign government bonds, mortgage-backed securities, and agency securities. Level 3 investments are valued using internally developed models with unobservable inputs. Assets and liabilities measured using unobservable inputs are an immaterial portion of our portfolio. 38 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 A majority of our investments are priced by pricing vendors and are generally Level 1 or Level 2 investments as these vendors either provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted price is not available, the investment is not priced by our pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally labeled as Level 2 investments because the broker prices these investments based on similar assets without applying significant adjustments. In addition, all of our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these investments. Our fair value processes include controls that are designed to ensure appropriate fair values are recorded. These controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and independent recalculation of prices where appropriate. Cash Flows Cash flows from operations increased $2.0 billion to $14.4 billion for the six months ended December 31, 2011 due mainly to increased revenue and cash collections. Cash used in financing decreased $2.0 billion to $5.4 billion due mainly to a $6.5 billion decrease in cash used for common stock repurchases, offset in part by a $3.7 billion net decrease in proceeds from issuances of debt. Cash used in investing increased $1.4 billion to $7.9 billion due mainly to a $9.4 billion increase in acquisitions of businesses and purchases of intangible assets and a $1.5 billion decrease in cash from securities lending activities, partially offset by a $9.5 billion increase in cash provided by net purchases, maturities, and sales of investments. Debt We issued debt in prior periods to take advantage of favorable pricing and liquidity in the debt markets, reflecting our credit rating and the low interest rate environment. The proceeds of these issuances were used to partially fund discretionary business acquisitions and share repurchases. As of December 31, 2011, the total carrying value and estimated fair value of our long-term debt, including convertible debt, were $11.9 billion and $13.1 billion, respectively. This is compared to a carrying value and estimated fair value of $11.9 billion and $12.1 billion, respectively, as of June 30, 2011. The estimated fair value is based on quoted prices for our publicly-traded debt as of December 31, 2011 and June 30, 2011, as applicable. The components of long-term debt, the associated interest rates, and the semi-annual interest record and payment dates were as follows as of December 31, 2011: Stated Effective Interest Interest Interest Interest Interest Interest Due Date Face Value Rate Rate Record Date Pay Date Record Date Pay Date----------------------------------------------------------------------------------------------------------------------------------------------------------- - (In millions ) Notes September 27, 2013 $ 1,000 0.875 % 1.000 % March 15 March 27 September 15 September 27 June 1, 2014 2,000 2.950 % 3.049 % May 15 June 1 November 15 December 1 September 25, 2015 1,750 1.625 % 1.795 % March 15 March 25 September 15 September 25 February 8, 2016 750 2.500 % 2.642 % February 1 February 8 August 1 August 8 June 1, 2019 1,000 4.200 % 4.379 % May 15 June 1 November 15 December 1 October 1, 2020 1,000 3.000 % 3.137 % March 15 April 1 September 15 October 1 February 8, 2021 500 4.000 % 4.082 % February 1 February 8 August 1 August 8 June 1, 2039 750 5.200 % 5.240 % May 15 June 1 November 15 December 1 October 1, 2040 1,000 4.500 % 4.567 % March 15 April 1 September 15 October 1 February 8, 2041 1,000 5.300 % 5.361 % February 1 February 8 August 1 August 8 ------------------------------------------------- -- Total 10,750 Convertible Debt June 15, 2013 1,250 0.000 % 1.849 % Total unamortized discount (68 ) ------------------------------------------------- -- Total $ 11,932 - ------------ -- 39 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Notes The Notes are senior unsecured obligations and rank equally with our other unsecured and unsubordinated debt outstanding. Convertible Debt In June 2010, we issued $1.25 billion of zero coupon convertible unsecured debt due on June 15, 2013 in a private placement offering. Proceeds from the offering were $1.24 billion, net of fees and expenses, which were capitalized. 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. As of December 31, 2011, the net carrying amount of our convertible debt was $1.2 billion and the unamortized discount was $28 million. Prior to March 15, 2013, the notes will be convertible, only in certain circumstances, into cash and, if applicable, cash, shares of Microsoft's common stock, or a combination thereof, at our election. On or after March 15, 2013, the notes will be convertible at any time. Upon conversion, we will pay cash up to the aggregate principal amount of the notes and pay or deliver cash, shares of our common stock or a combination of cash and shares of our common stock, at our election. Because the convertible debt may be wholly or partially settled in cash, we are required to separately account for the liability and equity components of the notes in a manner that reflects our nonconvertible debt borrowing rate when interest costs are recognized in subsequent periods. The net proceeds of $1.24 billion were allocated between debt for $1.18 billion and stockholders' equity for $58 million with the portion in stockholders' equity representing the fair value of the option to convert the debt. 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. Unearned Revenue Unearned revenue at December 31, 2011 comprised mainly unearned revenue from volume licensing programs. Unearned revenue from volume licensing programs represents customer billings for multi-year licensing arrangements paid for either at inception of the agreement or annually at the beginning of each billing coverage period and accounted for as subscriptions with revenue recognized ratably over the billing coverage period. Unearned revenue at December 31, 2011 also included payments for: post-delivery support and consulting services to be performed in the future; Xbox LIVE subscriptions and prepaid points; Microsoft Dynamics business solutions products; Skype prepaid credit and subscriptions; OEM minimum commitments; unspecified upgrades/enhancements of Windows Phone and of Microsoft Internet Explorer on a when-and-if-available basis for Windows XP; and other offerings for which we have been paid in advance and earn the revenue when we provide the service or software, or otherwise meet the revenue recognition criteria. The following table outlines the expected future recognition of unearned revenue as of December 31, 2011: (In millions) --------------------------------- - Three Months Ending, March 31, 2012 $ 6,236 June 30, 2012 4,380 September 30, 2012 2,229 December 31, 2012 1,140 Thereafter 1,349 --------------------------------- - Total $ 15,334 - -------- - 40 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Share Repurchases During the three and six months ended December 31, 2011, we repurchased approximately 39 million and 78 million shares of Microsoft common stock for $1.0 billion and $2.0 billion, respectively, under the repurchase plan we announced on September 22, 2008. All repurchases were made using cash resources. As of December 31, 2011, approximately $10.2 billion remained of the $40.0 billion approved repurchase amount. The repurchase program expires September 30, 2013 but may be suspended or discontinued at any time without notice. Dividends Our Board of Directors declared the following dividends during the periods presented: Dividend Declaration Date Per Share Record Date Total Amount Payment Date----------------------------------------------------------------------------------------------------------------------- - (in millions) Fiscal Year 2012 September 20, 2011 $ 0.20 November 17, 2011 $ 1,683 December 8, 2011 December 14, 2011 $ 0.20 February 16, 2012 $ 1,676 March 8, 2012 Fiscal Year 2011 September 21, 2010 $ 0.16 November 18, 2010 $ 1,363 December 9, 2010 December 15, 2010 $ 0.16 February 17,2011 $ 1,349 March 10, 2011 ----------------------------------------------------------------------------------------------------------------------- - Off-Balance Sheet Arrangements We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. In evaluating estimated losses on these indemnifications, we consider factors such as the degree of probability of an unfavorable outcome and our ability to make a reasonable estimate of the amount of loss. To date, we have not encountered significant costs as a result of these obligations and have not accrued in our financial statements any liabilities related to these indemnifications. Other Planned Uses of Capital We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology. Additions to property and equipment will continue, including new facilities, data centers, and computer systems for research and development, sales and marketing, support, and administrative staff. We have operating leases for most U.S. and international sales and support offices and certain equipment. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital resources. Liquidity We earn a significant amount of our operating income outside the U.S., which is deemed to be permanently reinvested in foreign jurisdictions. As a result, as discussed above under Cash, Cash Equivalents, and Investments, the majority of our cash, cash equivalents, and short-term investments are held by foreign subsidiaries. We currently do not intend nor foresee a need to repatriate these funds. We expect existing domestic cash, cash equivalents, short-term investments, and cash flows from operations to continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, such as regular quarterly dividends, debt repayment schedules, and material capital expenditures, for at least the next 12 months and thereafter for the foreseeable future. In addition, we expect existing foreign cash, cash equivalents, short-term investments, and cash flows from operations to continue to be sufficient to fund our foreign operating activities and cash commitments for investing activities, such as material capital expenditures, for at least the next 12 months and thereafter for the foreseeable future. Should we require more capital in the U.S. than is generated by our operations domestically, for example to fund significant discretionary activities, such as business acquisitions and share repurchases, we could elect to repatriate future earnings from foreign jurisdictions or raise capital in the U.S. through debt or equity issuances. These alternatives could result in higher effective tax rates, increased interest expense, or other dilution of our earnings. We have borrowed funds domestically and continue to have the ability to do so at reasonable interest rates. 41 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 RECENT ACCOUNTING GUIDANCE Recently Adopted Accounting Guidance On July 1, 2011, we adopted guidance issued by the Financial Accounting Standards Board ("FASB") on 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). Adoption of this new guidance did not have a material impact on our financial statements. Recent Accounting Guidance Not Yet Adopted In December 2011, the FASB issued guidance enhancing disclosure requirements about the nature of an entity's right to offset and related arrangements associated with its financial instruments and derivative instruments. The new guidance requires the disclosure of the gross amounts subject to rights of set-off, amounts offset in accordance with the accounting standards followed, and the related net exposure. The new guidance will be effective for us beginning July 1, 2013. Other than requiring additional disclosures, we do not anticipate material impacts on our financial statements upon adoption. In September 2011, the FASB issued guidance on testing goodwill for impairment. The new guidance provides an entity the option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If an entity determines that this is the case, it is required to perform the currently prescribed two-step goodwill impairment test to identify potential goodwill impairment and measure the amount of goodwill impairment loss to be recognized for that reporting unit (if any). If an entity determines the fair value of a reporting unit is greater than its carrying amount, the two-step goodwill impairment test is not required. The new guidance will be effective for us beginning July 1, 2012. In June 2011, the FASB issued guidance on presentation of comprehensive income. The new guidance eliminates the current option to report other comprehensive income and its components in the statement of changes in equity. Instead, an entity will be required to present either a continuous statement of net income and other comprehensive income or in two separate but consecutive statements. The new guidance also required entities to present reclassification adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which other comprehensive income is presented. In December 2011, the FASB issued guidance which indefinitely defers the guidance related to the presentation of reclassification adjustments. The new guidance will be effective for us beginning July 1, 2012 and will have financial statement presentation changes only. In May 2011, the FASB issued guidance to amend the accounting and disclosure requirements on fair value measurements. The new guidance limits the highest-and-best-use measure to nonfinancial assets, permits certain financial assets and liabilities with offsetting positions in market or counterparty credit risks to be measured at a net basis, and provides guidance on the applicability of premiums and discounts. Additionally, the new guidance expands the disclosures on Level 3 inputs by requiring quantitative disclosure of the unobservable inputs and assumptions, as well as description of the valuation processes and the sensitivity of the fair value to changes in unobservable inputs. The new guidance will be effective for us beginning January 1, 2012. Other than requiring additional disclosures, we do not anticipate material impacts on our financial statements upon adoption. APPLICATION OF CRITICAL ACCOUNTING POLICIES Our financial statements and accompanying notes are prepared in accordance with U.S. GAAP. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management's application of accounting policies. Critical accounting policies for us include revenue recognition, impairment of investment securities, goodwill, research and development costs, contingencies, income taxes, and stock-based compensation. Revenue Recognition Software revenue recognition requires judgment, including whether a software arrangement includes multiple elements, and if so, whether vendor-specific objective evidence ("VSOE") of fair value exists for those elements. A portion of revenue may be recorded as unearned due to undelivered elements. Changes to the elements in a software arrangement, the ability to identify VSOE for those elements, and the fair value of the respective elements could materially impact the amount of earned and unearned revenue. Judgment is also required to assess whether future releases of certain software represent new products or upgrades and enhancements to existing products. 42 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Impairment of Investment Securities Investments are reviewed quarterly for indicators of other-than-temporary impairment. This determination requires significant judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to sell, the investment. For fixed-income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded to other income (expense) and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments. Goodwill We allocate goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated using a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital. Among our reporting units, the fair value of OSD has been the closest to its carrying value and is most sensitive to changes in assumptions. As of the date of our most recent goodwill impairment test, May 1, 2011, OSD's fair value exceeded its carrying value by 21%. The carrying value of OSD's goodwill was $6.4 billion as of December 31, 2011. The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results and market conditions. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit. Research and Development Costs Costs incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, all software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to manufacturing. The amortization of these costs is included in cost of revenue over the estimated life of the products. Legal and Other Contingencies The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency such as a legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. Disclosure of a contingency is required if there is at least a reasonable possibility that a loss has been incurred. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our financial statements. 43 -------------------------------------------------------------------------------- Table of Contents PART I Item 2, 3 Income Taxes The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity's financial statements or tax returns. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Accounting literature also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our financial statements. Stock-Based Compensation Stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service period. Determining the fair value of stock-based awards at the grant date requires judgment, including estimating expected dividends. In addition, judgment is also required in estimating the amount of stock-based awards that are expected to be forfeited. If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations could be impacted. |