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MICROSOFT CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND(Edgar Glimpses Via Acquire Media NewsEdge) RESULTS OF OPERATIONS Note About Forward-Looking Statements This report includes estimates, projections, statements relating to our business plans, objectives and expected operating results that 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 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 that may cause actual results to differ materially. We describe risks and uncertainties that could cause actual results and events to differ materially in "Risk Factors" (Part II, Item 1A of this Form 10-Q), "Quantitative and Qualitative Disclosures about Market Risk" (Part I, Item 3), and "Management's Discussion and Analysis" (Part I, Item 2). 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, 2013, our Form 8-K filed on November 26, 2013, and our financial statements and accompanying Notes to Financial Statements in this Form 10-Q. Microsoft is a technology leader focused on helping people and businesses throughout the world realize their full potential. We create technology that transforms the way people work, play, and communicate across a wide range of computing devices. We generate revenue by developing, licensing, and supporting a wide range of software products, by offering an array of services, including cloud-based services to consumers and businesses, by designing, manufacturing and selling devices that integrate with our cloud-based services, and by delivering relevant online advertising to a global audience. Our most significant expenses are related to compensating employees, designing, manufacturing, marketing, and selling our products and services, and income taxes. Industry Trends Our industry is dynamic and highly competitive, with frequent changes in both technologies and business models. Each industry shift is an opportunity to conceive new products, new technologies, or new ideas that can further transform the industry and our business. At Microsoft, we push the boundaries of what is possible through a broad range of research and development activities that seek to identify and address 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 generate future growth. We invest research and development resources in new products and services in these areas. The capabilities and accessibility of PCs, tablets, phones, televisions, and other devices powered by rich software platforms and applications continue to grow. With this trend, we believe the full potential of software will be seen and felt in how people use these devices and the associated services at work and in their personal lives. Devices with end-user services We work with an ecosystem of partners to deliver a broad spectrum of Windows devices. In some cases we build our own devices, as we do with Xbox and Surface. Surface RT and Surface Pro were released October 26, 2012 and February 9, 2013, respectively, and Surface 2 and Surface Pro 2 were released October 22, 2013. Xbox One was released on November 22, 2013. 31 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 In all of our work with partners and on our own devices, we focus on delivering seamless services and experiences across devices. As consumer services and hardware advance, we expect they will continue to better complement one another, connecting the devices people use daily to unique communications, productivity, and entertainment services from Microsoft and our partners and developers around the world. Windows 8 reflects this shift. Windows 8 was designed to unite the light, thin, and convenient aspects of a tablet with the power of a PC. The Windows 8 operating system includes the Windows Store, which offers a large and growing number of applications from Microsoft and partners for both business and consumer customers. Windows 8.1 enables new hardware and furthers the integration with other Microsoft services. Going forward, our strategy will focus on creating a family of devices and services for individuals and businesses that empower people around the globe at home, at work, and on the go, for the activities they value most. This strategy will require investment in datacenters and other infrastructure to support our devices and services, and will bring continued competition with Apple, Google, and other well-established and emerging competitors. We believe our history of powering devices such as Windows PCs and Xbox, as well as our experience delivering high-value experiences through Microsoft Office and other applications, will position us for future success. Services for the enterprise Today, businesses face important opportunities and challenges. Enterprises are asked to deploy technology that drives business strategy forward. They decide what solutions will make employees more productive, collaborative, and satisfied, or connect with customers in new and compelling ways. They work to unlock business insights from a world of data. At the same time, they must manage and secure corporate information that employees access across a growing number of personal and corporate devices. To address these opportunities, businesses look to our world-class business applications like Office, Exchange, SharePoint, Lync, Yammer, Microsoft Dynamics, and our business intelligence solutions. They rely on our technology to manage employee corporate identity and to protect their corporate data. And, increasingly, businesses of all sizes are looking to Microsoft to realize the benefits of the cloud. Helping businesses move to the cloud is one of our largest opportunities. Cloud-based solutions provide customers with software, services, and content over the Internet by way of shared computing resources located in centralized datacenters. The shift to the cloud is driven by three important economies of scale: larger datacenters can deploy computational resources at significantly lower cost per unit than smaller ones; larger datacenters can coordinate and aggregate diverse customer, geographic, and application demand patterns improving the utilization of computing, storage, and network resources; and multi-tenancy lowers application maintenance labor costs for large public clouds. Because of the improved economics, the cloud offers unique levels of elasticity and agility that enable new solutions and applications. For businesses of all sizes, the cloud creates the opportunity to focus on innovation while leaving non-differentiating activities to reliable and cost-effective providers. We continue to design and deliver cloud solutions that allow our customers to use both the cloud and their on-premise assets however best suits their own needs. For example, a company can choose to deploy Office or Microsoft Dynamics on premise, as a cloud service, or a combination of both. With Windows Server 2012, Microsoft Azure, and System Center infrastructure, businesses can deploy applications in their own datacenter, a partner's datacenter, or in Microsoft's datacenter with common security, management, and administration across all environments, with the flexibility and scale they want. These hybrid capabilities allow customers to fully harness the power of the cloud so they can achieve greater levels of efficiency and tap new areas of growth. Our future opportunity There are several distinct areas of technology that we are focused on driving forward. Our goal is to lead the industry in these areas over the long term, which we expect will translate to sustained growth well into the future. We are investing significant resources in: • Developing new form factors that have increasingly natural ways to use them, including touch, gesture, and speech. • Applying machine learning to make technology more intuitive and able to act on our behalf, instead of at our command. 32 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 • Building and running cloud-based services in ways that unleash new experiences and opportunities for businesses and individuals. • Establishing our Windows platform across the PC, tablet, phone, server, and additional devices, as well as the cloud, to drive a thriving ecosystem of developers, unify the cross-device user experience, and increase agility when bringing new advances to market. • Delivering new high-value experiences with improvements in how people learn, work, play, and interact with one another. We believe the breadth of our devices and services portfolio, our large, global partner and customer base, and the growing Windows ecosystem position us to be a leader in these areas. Economic Conditions, Challenges, and Risks The market for software, devices, and cloud-based services is dynamic and highly competitive. Some of our traditional businesses such as the Windows operating system are in a period of transition. Our competitors are developing new devices and deploying competing cloud-based services for consumers and businesses. The devices and form factors customers prefer evolve rapidly, and influence how users access services in the cloud and in some cases the user's choice of which suite of cloud-based services to use. The Windows ecosystem must continue to evolve and adapt over an extended time in pace with this changing environment. To support our strategy of offering a family of devices and services designed to empower our customers for the activities they value most, we announced a change in our organizational structure in July 2013. Through this realignment, our goal is to become more nimble, collaborative, communicative, motivated, and decisive. Even if we achieve these benefits, the investments we are making in devices and infrastructure to support our cloud-based services will increase our operating costs and may decrease our operating margins. We prioritize our investments among the highest long-term growth opportunities. These investments require significant resources and are multi-year in nature. The products and services we bring to market may be developed internally, as part of a partnership or alliance, or through acquisition. Our success is highly dependent on our ability to attract and retain qualified employees. We hire a mix of university and industry talent worldwide. Microsoft competes for talented individuals worldwide by offering broad customer reach, scale in resources, and competitive compensation. Aggregate demand for our software, services, and hardware is correlated to global macroeconomic factors, which remain dynamic. See a discussion of these factors and other risks under Risk Factors (Part II, Item 1A of this Form 10-Q). Unearned Revenue Quarterly and annual revenue may be impacted by the deferral of revenue. See the discussions within Corporate and Other below regarding: • revenue deferred on certain devices bundled with other products and services ("Bundled Offerings"); • revenue deferred on sales of Windows 7 with an option to upgrade to Windows 8 Pro at a discounted price (the "Windows Upgrade Offer"); • revenue deferred on sales of the previous version of the Microsoft Office system with a guarantee to be upgraded to the new Office at minimal or no cost (the "Office Upgrade Offer") and pre-sales of the new Office to original equipment manufacturers ("OEMs") and retailers before general availability (collectively, the "Office Deferral"); and • revenue deferred on sales of video games with the right to receive specified software upgrades/enhancements (the "Video Game Deferral"). If our customers elect to license cloud-based versions of our products and services rather than licensing transaction-based products and services, the associated revenue will shift from being recognized at the time of the transaction to being recognized over the subscription period or upon consumption, as applicable. Reportable Segments The segment amounts included in MD&A are presented on a basis consistent with our internal management reporting. Segment information appearing in Note 16 - Segment Information in the Notes to Financial Statements 33 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 (Part I, Item 1 of this Form 10-Q) is also presented on this basis. All differences between our internal management reporting basis and accounting principles generally accepted in the U.S. ("U.S. GAAP"), along with certain corporate-level and other activity, are included in Corporate and Other. Operating expenses are not allocated to our segments. During the first quarter of fiscal year 2014, we changed our organizational structure as part of our transformation to a devices and services company. As a result, information that our chief operating decision maker regularly reviews for purposes of allocating resources and assessing performance changed. Therefore, we have recast certain prior period amounts to conform to the way we internally manage and monitor segment performance during fiscal year 2014. Our reportable segments are described below. Devices and Consumer ("D&C") Our D&C segments develop, market, and support products and services designed to entertain and connect people, increase personal productivity, help people simplify tasks and make more informed decisions online, and help advertisers connect with audiences. Our D&C segments are: • D&C Licensing, comprising: Windows, including all OEM licensing ("Windows OEM") and other non-volume licensing and academic volume licensing of the Windows operating system and related software (collectively, "Consumer Windows"); non-volume licensing of Microsoft Office, comprising the core Office product set, for consumers ("Consumer Office"); Windows Phone, including related patent licensing; and certain other patent licensing revenue; • D&C Hardware, comprising: Xbox gaming and entertainment consoles and accessories, second-party and third-party video game royalties, and Xbox Live subscriptions ("Xbox Platform"); Surface; and Microsoft PC accessories; and • D&C Other, comprising: Resale, including Windows Store, Xbox Live transactions, and Windows Phone Store; search advertising; display advertising; Subscription, comprising Office 365 Home and Office 365 Personal; Studios, comprising first-party video games; our retail stores; and certain other consumer products and services not included in the categories above. Commercial Our Commercial segments develop, market, and support software and services designed to increase individual, team, and organizational productivity and efficiency, including simplifying everyday tasks through seamless operations across the user's hardware and software. Our Commercial segments are: • Commercial Licensing, comprising: server products, including Windows Server, Microsoft SQL Server, Visual Studio, and System Center; Windows Embedded; volume licensing of the Windows operating system, excluding academic ("Commercial Windows"); Microsoft Office for business, including Office, Exchange, SharePoint, and Lync ("Commercial Office"); Client Access Licenses, which provide access rights to certain server products ("CAL"); Microsoft Dynamics business solutions, excluding Dynamics CRM Online; and Skype; and • Commercial Other, comprising: Enterprise Services, including Premier Support Services and Microsoft Consulting Services; Cloud Services, comprising Office 365, excluding Office 365 Home and Office 365 Personal ("Commercial Office 365"), other Microsoft Office online offerings, Dynamics CRM Online, and Microsoft Azure; and certain other commercial products and online services not included in the categories above. SUMMARY RESULTS OF OPERATIONS Summary (In millions, except percentages and per share Three Months Ended Percentage Nine Months Ended Percentage amounts) March 31, Change March 31, Change------------------------------------------------------------------------------------------------------------------------- - 2014 2013 2014 2013 Revenue $ 20,403 $ 20,489 (0)% $ 63,451 $ 57,953 9% Operating income $ 6,974 $ 7,612 (8)% $ 21,277 $ 20,691 3% Diluted earnings per share $ 0.68 $ 0.72 (6)% $ 2.08 $ 1.99 5%------------------------------------------------------------------------------------------------------------------------- - 34 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Three months ended March 31, 2014 compared with three months ended March 31, 2013 Revenue grew $1.7 billion across our reportable segments, while Corporate and Other revenue declined $1.8 billion due to the prior year recognition of deferred revenue related to the Windows Upgrade Offer, the Video Game Deferral, and the Office Deferral. Cloud Services revenue doubled, reflecting continued growth from our cloud-based offerings. Cost of revenue increased $1.2 billion or 24%, primarily due to higher volumes of Xbox and Surface sold, as well as $159 million higher datacenter expenses. Operating income decreased $638 million or 8%, reflecting higher cost of revenue, offset in part by lower general and administrative expenses and sales and marketing expenses. Key changes in operating expenses were: • General and administrative expenses decreased $453 million or 27%, primarily due to the EU fine in the prior year. • Sales and marketing expenses decreased $252 million or 7%, due mainly to lower advertising costs, offset in part by increased headcount. Nine months ended March 31, 2014 compared with nine months ended March 31, 2013 Revenue increased $5.5 billion or 9%, primarily due to higher D&C Hardware, Commercial Licensing, and Commercial Other revenue. Cloud Services revenue doubled, reflecting continued growth from our cloud-based offerings. Cost of revenue increased $4.7 billion or 32%, primarily due to higher volumes of Xbox and Surface sold, as well as $490 million higher datacenter expenses. Operating income increased $586 million or 3%, reflecting higher revenue and lower general and administrative expenses, offset in part by higher cost of revenue and research and development expenses. Key changes in operating expenses were: • Research and development expenses increased $630 million or 8%, due mainly to increased investment in new products and services in our Devices and Studios and Applications and Services engineering groups, and higher capitalization of new product development costs in the prior year. • General and administrative expenses decreased $491 million or 12%, primarily due to the EU fine in the prior year. 35 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 SEGMENT RESULTS OF OPERATIONS Devices and Consumer Three Months Ended Percentage Nine Months Ended Percentage (In millions, except percentages) March 31, Change March 31, Change ----------------------------------------------------------------------------------------------------------------------------- - 2014 2013 2014 2013 Revenue Licensing $ 4,382 $ 4,352 1% $ 14,109 $ 14,733 (4)% Hardware 1,973 1,402 41% 8,187 5,294 55% Other 1,950 1,656 18% 5,378 5,055 6% ---------------------------------------------- - - -------- - - -------- - - -------- - Total revenue $ 8,305 $ 7,410 12% $ 27,674 $ 25,082 10% - -------- - - -------- - - -------- - - -------- - Gross Margin Licensing $ 3,906 $ 3,929 (1)% $ 12,809 $ 13,163 (3)% Hardware 258 393 (34)% 875 1,603 (45)% Other 541 430 26% 1,324 1,678 (21)% ---------------------------------------------- - - -------- - - -------- - - -------- - Total gross margin $ 4,705 $ 4,752 (1)% $ 15,008 $ 16,444 (9)% - -------- - - -------- - - -------- - - -------- - Three months ended March 31, 2014 compared with three months ended March 31, 2013 D&C revenue increased $895 million or 12%, reflecting sales of Xbox One and Surface, as well as higher online advertising revenue. D&C gross margin decreased slightly, reflecting changes in the mix of products and services sold. Nine months ended March 31, 2014 compared with nine months ended March 31, 2013 D&C revenue increased $2.6 billion or 10%, reflecting sales of Xbox One and Surface, as well as higher Windows Phone revenue and online advertising revenue, offset in part by lower revenue from licenses of Consumer Windows and Consumer Office. D&C gross margin decreased $1.4 billion or 9%, reflecting changes in the mix of products and services sold and higher online advertising cost of revenue. D&C Licensing Three months ended March 31, 2014 compared with three months ended March 31, 2013 D&C Licensing revenue increased slightly, due mainly to higher revenue from licenses of Consumer Office and Consumer Windows, including the impact of the expiration of support for Windows XP and higher volume in Japan. Consumer Office revenue increased 15%, due mainly to higher volumes of licenses sold, offset in part by the impact on revenue of continued softness in the consumer PC market. Windows OEM revenue increased 4%, reflecting a 19% increase in OEM Pro revenue, offset in part by continued softness in the consumer PC market. D&C Licensing gross margin decreased slightly, due mainly to an increase in cost of revenue. Nine months ended March 31, 2014 compared with nine months ended March 31, 2013 D&C Licensing revenue decreased $624 million or 4%, due mainly to lower revenue from licenses of Consumer Windows and Consumer Office, offset in part by increased Windows Phone revenue. Retail and non-OEM sales of Windows declined $319 million or 50%, due mainly to the launch of Windows 8 in the prior year. Windows OEM revenue declined $226 million or 2%, reflecting continued softness in the consumer PC market, offset in part by a 12% increase in OEM Pro revenue. Consumer Office revenue declined $368 million or 14%, reflecting the transition of customers to Office 365 Home as well as the impact on revenue of continued softness in the consumer PC market. Windows Phone revenue increased $429 million or 33%, reflecting an increase in mobile phone patent licensing revenue and higher sales of Windows Phone licenses. 36 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 D&C Licensing gross margin decreased $354 million or 3%, due to decreased revenue, offset in part by a $270 million or 17% decrease in cost of revenue. D&C Licensing cost of revenue decreased, due mainly to a $231 million decline in traffic acquisition costs. D&C Hardware Three months ended March 31, 2014 compared with three months ended March 31, 2013 D&C Hardware revenue increased $571 million or 41%, due primarily to $398 million or 45% higher Xbox Platform revenue as well as Surface revenue growth. Surface revenue was $494 million for the three months ended March 31, 2014. Xbox Platform revenue increased due to sales of Xbox One, which sells for a higher price than Xbox 360. We sold 2.0 million Xbox consoles during the third quarter of fiscal year 2014, compared with 1.3 million Xbox consoles during the third quarter of fiscal year 2013. Surface revenue increased due to a higher number of units sold. D&C Hardware gross margin decreased $135 million or 34%, due to a $706 million or 70% increase in cost of revenue, offset in part by higher revenue. Xbox Platform cost of revenue increased $486 million, due mainly to higher volumes of consoles sold and higher costs associated with Xbox One. Surface cost of revenue was $539 million for the three months ended March 31, 2014, which increased due mainly to a higher number of units sold. Nine months ended March 31, 2014 compared with nine months ended March 31, 2013 D&C Hardware revenue increased $2.9 billion or 55%, due primarily to $1.5 billion or 38% higher Xbox Platform revenue as well as Surface revenue growth. Surface revenue was $1.8 billion for the nine months ended March 31, 2014. Xbox Platform revenue increased due to sales of Xbox One, which sells for a higher price than Xbox 360. We sold 10.6 million Xbox consoles during the first nine months of fiscal year 2014 compared with 8.9 million Xbox consoles during the first nine months of fiscal year 2013. Surface revenue increased due to a higher number of units sold. D&C Hardware gross margin decreased $728 million or 45%, due to a $3.6 billion or 98% increase in cost of revenue, offset in part by higher revenue. Xbox Platform cost of revenue increased $2.0 billion, due mainly to higher volumes of consoles sold and higher costs associated with Xbox One. Surface cost of revenue was $2.1 billion for the nine months ended March 31, 2014, which increased due mainly to a higher number of units sold. D&C Other Three months ended March 31, 2014 compared with three months ended March 31, 2013 D&C Other revenue increased $294 million or 18%, due mainly to an increase in online advertising revenue and Subscription revenue. Online advertising revenue increased $144 million or 16%. Search advertising revenue increased 38%, due primarily to increased revenue per search resulting from ongoing improvements in advertising products and higher search volume, offset in part by a 24% reduction in display advertising revenue. Subscription revenue was $98 million for the three months ended March 31, 2014, reflecting subscriber growth of Office 365 Home. D&C Other gross margin increased $111 million or 26%, due to an increase in revenue, offset in part by a $183 million or 15% increase in cost of revenue. D&C Other cost of revenue grew, due mainly to a $123 million or 21% increase in online advertising cost of revenue, reflecting support of online infrastructure. Nine months ended March 31, 2014 compared with nine months ended March 31, 2013 D&C Other revenue increased $323 million or 6%, due mainly to higher online advertising revenue and Subscription revenue, offset in part by a $267 million decrease in first-party video games revenue, primarily due to the release of Halo 4 in the second quarter of fiscal year 2013. Online advertising revenue increased $309 million or 12%. Search advertising revenue increased 39%, due primarily to increased revenue per search resulting from ongoing improvements in advertising products and higher search volume, offset in part by a 29% reduction in display advertising revenue. Subscription revenue was $212 million for the nine months ended March 31, 2014, reflecting subscriber growth of Office 365 Home. D&C Other revenue also increased $128 million or 11%, due to higher revenue from content resold through our online platforms. D&C Other gross margin decreased $354 million or 21%, due to a $677 million or 20% increase in cost of revenue, offset in part by higher revenue. D&C Other cost of revenue grew, due mainly to a $388 million or 23% increase in online advertising cost of revenue, reflecting support of online infrastructure and higher traffic acquisition costs. D&C Other cost of revenue also increased $219 million or 20%, due to higher resale transactions costs. 37 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Commercial Three Months Ended Percentage Nine Months Ended Percentage (In millions, except percentages) March 31, Change March 31, Change --------------------------------------------------------------------------------------------------------------------------------- - 2014 2013 2014 2013 Revenue Licensing $ 10,323 $ 9,979 3% $ 30,805 $ 29,059 6% Other 1,902 1,449 31% 5,285 4,086 29%----------------------------------------------- - - --------- - - --------- - - --------- - Total revenue $ 12,225 $ 11,428 7% $ 36,090 $ 33,145 9% - --------- - - --------- - - --------- - - --------- - Gross Margin Licensing $ 9,430 $ 9,085 4% $ 28,308 $ 26,594 6% Other 475 264 80% 1,165 585 99%----------------------------------------------- - - --------- - - --------- - - --------- - Total gross margin $ 9,905 $ 9,349 6% $ 29,473 $ 27,179 8% - --------- - - --------- - - --------- - - --------- - Three months ended March 31, 2014 compared with three months ended March 31, 2013 Commercial revenue increased $797 million or 7%, due to growth in revenue from Cloud Services and our on-premise licensing businesses. Collectively, Commercial Office and Commercial Office 365 revenue grew 6%. Commercial gross margin increased $556 million or 6%, in line with revenue growth. Nine months ended March 31, 2014 compared with nine months ended March 31, 2013 Commercial revenue increased $2.9 billion or 9%, due to growth in revenue from our on-premise licensing businesses and Cloud Services. Collectively, Commercial Office and Commercial Office 365 revenue grew 9%. Commercial gross margin increased $2.3 billion or 8%, in line with revenue growth. Commercial Licensing Three months ended March 31, 2014 compared with three months ended March 31, 2013 Commercial Licensing revenue increased $344 million or 3%, due primarily to increased revenue from our server products, including related CAL, and Commercial Windows, offset in part by the transition of customers to Cloud Services. Our server products revenue grew $313 million or 8%, driven primarily by increased sales of Microsoft SQL Server. Commercial Windows revenue grew $90 million or 11%. Commercial Licensing gross margin increased $345 million or 4%, due mainly to higher revenue. Nine months ended March 31, 2014 compared with nine months ended March 31, 2013 Commercial Licensing revenue increased $1.7 billion or 6%, due primarily to increased revenue from our server products and Commercial Office, each including related CAL, and Commercial Windows. Our server products revenue grew $1.1 billion or 10%, driven primarily by increased sales of Microsoft SQL Server. Commercial Office revenue grew 4%. Commercial Office revenue was impacted by customers transitioning to Commercial Office 365. Commercial Windows revenue grew $230 million or 9%. Commercial Licensing gross margin increased $1.7 billion or 6%, due mainly to higher revenue. 38 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Commercial Other Three months ended March 31, 2014 compared with three months ended March 31, 2013 Commercial Other revenue increased $453 million or 31%, due to higher Cloud Services revenue and Enterprise Services revenue. Cloud Services revenue grew $367 million or 101%, due mainly to higher revenue from Commercial Office 365. Enterprise Services revenue grew $85 million or 8%, due mainly to growth in Premier Support Services and Microsoft Consulting Services. Commercial Other gross margin increased $211 million or 80%, due to higher revenue, offset in part by a $242 million or 20% increase in cost of revenue. The increase in cost of revenue was due mainly to higher datacenter expenses, reflecting support of online infrastructure. Nine months ended March 31, 2014 compared with nine months ended March 31, 2013 Commercial Other revenue increased $1.2 billion or 29%, due to higher Cloud Services revenue and Enterprise Services revenue. Cloud Services revenue grew $943 million or 104%, due mainly to higher revenue from Commercial Office 365. Enterprise Services revenue grew $254 million or 8%, due mainly to growth in Premier Support Services. Commercial Other gross margin increased $580 million or 99%, due to higher revenue, offset in part by a $619 million or 18% increase in cost of revenue. The increase in cost of revenue was due mainly to higher datacenter expenses, reflecting support of online infrastructure. Corporate and Other Three Months Ended Percentage Nine Months Ended Percentage (In millions, except percentages) March 31, Change March 31, Change -------------------------------------------------------------------------------------------------------------------------------- - 2014 2013 2014 2013 Revenue $ (127 ) $ 1,651 * $ (313 ) $ (274 ) (14)% Gross margin $ (148 ) $ 1,601 * $ (369 ) $ (317 ) (16)%-------------------------------------------------------------------------------------------------------------------------------- - * Not meaningful Corporate and Other revenue comprises certain revenue deferrals, including those related to product and service upgrade offers and pre-sales of new products to OEMs prior to general availability, as well as deferrals related to certain bundled product and service offerings. Three months ended March 31, 2014 compared with three months ended March 31, 2013 Corporate and Other revenue decreased $1.8 billion, primarily due to the recognition of previously deferred revenue in the prior year. During the three months ended March 31, 2014, we deferred a net $110 million of revenue related to Bundled Offerings. During the three months ended March 31, 2013 we recognized $1.1 billion, $380 million, and a net $193 million of previously deferred revenue related to the Windows Upgrade Offer, Video Game Deferral, and the Office Deferral, respectively. Corporate and Other gross margin decreased $1.7 billion, in line with revenue. Nine months ended March 31, 2014 compared with nine months ended March 31, 2013 Corporate and Other revenue decreased slightly, primarily due to the timing of revenue deferrals. During the nine months ended March 31, 2014, we deferred a net $260 million of revenue related to Bundled Offerings. During the nine months ended March 31, 2013, we deferred a net $784 million of revenue related to the Office Upgrade Offer, offset in part by the recognition of $540 million of previously deferred revenue related to the Windows Upgrade Offer. Corporate and Other gross margin decreased slightly, in line with revenue. 39 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 OPERATING EXPENSES Research and Development Three Months Ended Percentage Nine Months Ended Percentage (In millions, except percentages) March 31, Change March 31, Change --------------------------------------------------------------------------------------------------------------------------- - 2014 2013 2014 2013 Research and development $ 2,743 $ 2,640 4% $ 8,258 $ 7,628 8% As a percent of revenue 13% 13% 0ppt 13% 13% 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. Three months ended March 31, 2014 compared with three months ended March 31, 2013 Research and development expenses increased $103 million or 4%, due mainly to increased investment in new products and services in our Devices and Studios and Applications and Services engineering groups. Nine months ended March 31, 2014 compared with nine months ended March 31, 2013 Research and development expenses increased $630 million or 8%, due mainly to increased investment in new products and services in our Devices and Studios and Applications and Services engineering groups, and $167 million higher capitalization of new product development costs in the prior year, primarily related to Office 2013 and Windows 8. Sales and Marketing Three Months Ended Percentage Nine Months Ended Percentage (In millions, except percentages) March 31, Change March 31, Change ----------------------------------------------------------------------------------------------------------------------------- - 2014 2013 2014 2013 Sales and marketing $ 3,542 $ 3,794 (7)% $ 11,129 $ 11,048 1% As a percent of revenue 17% 19% (2)ppt 18% 19% (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. Three months ended March 31, 2014 compared with three months ended March 31, 2013 Sales and marketing expenses decreased $252 million or 7%, reflecting lower advertising costs, offset in part by increased headcount-related expenses. Advertising costs declined $342 million or 51%, primarily due to Windows 8, Surface, and Office costs in the prior year. Average headcount grew 5% to enhance sales execution and expand our retail stores presence. Nine months ended March 31, 2014 compared with nine months ended March 31, 2013 Sales and marketing expenses increased slightly, primarily due to headcount-related expenses and other investment in our retail stores, offset in part by lower advertising costs. Average headcount grew 4% to enhance sales execution and expand our retail stores presence. Advertising costs declined $248 million or 13%, primarily due to Windows 8, Surface, and Office costs in the prior year. 40 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 General and Administrative Three Months Ended Percentage Nine Months Ended Percentage (In millions, except percentages) March 31, Change March 31, Change ----------------------------------------------------------------------------------------------------------------------------- - 2014 2013 2014 2013 General and administrative $ 1,203 $ 1,656 (27)% $ 3,448 $ 3,939 (12)% As a percent of revenue 6% 8% (2)ppt 5% 7% (2)ppt----------------------------------------------------------------------------------------------------------------------------- - 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. Three months ended March 31, 2014 compared with three months ended March 31, 2013 General and administrative expenses decreased $453 million or 27%, due mainly to a European Commission fine of €561 million (approximately $733 million) in the prior year for failure to comply with our 2009 agreement to display a "Browser Choice Screen" on Windows PCs where Internet Explorer is the default browser (the "EU fine"), offset in part by lower legal settlements and business taxes in the prior year. Nine months ended March 31, 2014 compared with nine months ended March 31, 2013 General and administrative expenses decreased $491 million or 12%, due mainly to the EU fine in the prior year, offset in part by lower legal settlements and business taxes in the prior year as well as costs associated with preparing to close the acquisition and integrate Nokia Corporation's ("Nokia") Devices and Services business. OTHER INCOME (EXPENSE) The components of other income (expense) were as follows: Three Months Ended Nine Months Ended (In millions) March 31, March 31,------------------------------------------------------------------------------------------------------- -- 2014 2013 2014 2013 Dividends and interest income $ 220 $ 150 $ 618 $ 475 Interest expense (175 ) (109 ) (428 ) (309 ) Net recognized gains on investments 90 57 153 85 Net losses on derivatives (50 ) (5 ) (253 ) (66 ) Net losses on foreign currency remeasurements (30 ) (22 ) (21 ) (58 ) Other (72 ) (80 ) (103 ) 89 ------------------------------------------------------------- --- - ----- -- -- ------ -- - ----- -- Total $ (17 ) $ (9 ) $ (34 ) $ 216 -- ------ --- - ----- -- -- ------ -- - ----- -- We use derivative instruments to: manage risks related to foreign currencies, equity prices, interest rates, and credit; enhance investment returns; and facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedges are 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 other comprehensive income ("OCI") until the securities are sold or other-than-temporarily impaired, at which time the amounts are reclassified from accumulated other comprehensive income ("AOCI") into other income (expense). Three months ended March 31, 2014 compared with three months ended March 31, 2013 Dividends and interest income increased due to higher portfolio balances. Interest expense increased due to higher outstanding long-term debt. Net losses on derivatives increased due to higher losses on foreign exchange contracts, offset in part by gains on commodity derivatives. For the three months ended March 31, 2014, other includes recognized losses from certain joint ventures. Nine months ended March 31, 2014 compared with nine months ended March 31, 2013 Dividends and interest income increased due to higher portfolio balances. Interest expense increased due to higher outstanding long-term debt. Net losses on derivatives increased due to higher losses on foreign exchange contracts, 41 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 losses on equity derivatives as compared to gains in the prior period, offset in part by higher gains on commodity derivatives. For the nine months ended March 31, 2014 other reflects recognized losses from certain joint ventures, offset in part by a recognized gain on a divestiture. For the nine months ended March 31, 2013, other reflects recognized gains on divestitures, including the gain recognized on the divestiture of our 50% share in the MSNBC joint venture. INCOME TAXES Our effective tax rates were approximately 19% and 20% for the three months ended March 31, 2014 and 2013, respectively, and 18% and 19% for the nine months ended March 31, 2014 and 2013, respectively. Our effective tax rate was lower than the U.S. federal statutory rate primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico. The current quarter's effective tax rate was lower than the prior year's third quarter effective tax rate, primarily due to nonrecurring items in the prior year's third quarter effective tax rate, such as the non-deductible EU fine and transfer pricing developments related to Denmark and India which were offset by adjustments to prior year tax provision estimates and unfavorable changes in the proportion of earnings taxed at lower rates in foreign jurisdictions. The current year's effective tax rate was lower than the prior year's effective tax rate, primarily due to additional U.S. tax relief determined to be available with respect to transfer pricing developments in certain foreign tax jurisdictions, primarily Denmark. Tax contingencies and other tax liabilities were $9.4 billion as of March 31, 2014 and June 30, 2013, and were included in other long-term liabilities. While we settled a portion of the U.S. Internal Revenue Service ("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. In February 2012, the I.R.S. withdrew its 2011 Revenue Agents Report and reopened the audit phase of the examination. As of March 31, 2014, the primary unresolved issue related to transfer pricing which could have a significant impact on our financial statements if not resolved favorably. We do not believe it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months, as we do not believe the remaining open issues will be resolved within the next 12 months. We also continue to be subject to examination by the I.R.S. for tax years 2007 to 2013. We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2013, some of which are currently under audit by local tax authorities. The resolutions of these audits are not expected to be material to our financial statements. FINANCIAL CONDITION Cash, Cash Equivalents, and Investments Cash, cash equivalents, and short-term investments totaled $88.4 billion as of March 31, 2014, compared with $77.0 billion as of June 30, 2013. Equity and other investments were $14.8 billion as of March 31, 2014, compared to $10.8 billion as of June 30, 2013. 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. 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 March 31, 2014, $80.8 billion was held by our foreign subsidiaries and would be subject to material repatriation tax effects. The amount of cash, cash equivalents, and short-term investments held by foreign subsidiaries subject to other restrictions on the free flow of funds (primarily currency and other local regulatory) was $1.3 billion. As of March 31, 2014, approximately 76% of the cash equivalents and short-term investments held by our foreign subsidiaries were invested in U.S. government and agency securities, approximately 4% were invested in corporate notes and bonds of U.S. companies, and approximately 1% were invested in U.S. mortgage-backed securities, all of which are denominated in U.S. dollars. 42 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 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 $794 million as of March 31, 2014. Our average and maximum securities lending payable balances for the three months ended March 31, 2014 were $670 million and $1.3 billion, respectively. Our average and maximum securities lending payable balances for the nine months ended March 31, 2014 were $598 million and $1.3 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. government securities. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments such as corporate notes and bonds, foreign government bonds, mortgage-backed securities, and U.S. agency securities. Level 3 investments are valued using internally developed models with unobservable inputs. Assets and liabilities measured at fair value on a recurring basis 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 classified as Level 2 investments because the broker prices these investments based on similar assets without applying significant adjustments. In addition, all of our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these investments. Our fair value processes include controls that are designed to ensure appropriate fair values are recorded. These controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and independent recalculation of prices where appropriate. Cash Flows Cash flows from operations decreased $213 million or 1%, to $22.7 billion for the nine months ended March 31, 2014, primarily due to lower revenue deferrals, partially offset by increased revenue from sales of devices. Cash used in financing decreased $1.6 billion or 24%, to $5.1 billion, due mainly to a $4.7 billion increase in proceeds from issuances of debt, net of repayments, partially offset by a $1.8 billion increase in cash used for common stock repurchases, and a $1.0 billion increase in dividends paid. Cash used in investing decreased $8.0 billion or 45%, to $9.9 billion, due mainly to a $8.1 billion decrease in cash used for net investment purchases, sales, and maturities, a $1.3 billion decrease in cash used for acquisition of companies and purchases of intangible and other assets, and a $398 million increase in cash from securities lending activities, partially offset by a $1.7 billion increase in capital expenditures for property and equipment. Debt We issued debt to take advantage of favorable pricing and liquidity in the debt markets, reflecting our credit rating and the low interest rate environment. The proceeds of these issuances were or will be used for general corporate purposes, which may include, among other things, funding for working capital, capital expenditures, repurchases of capital stock, acquisitions, and repayment of existing debt. 43 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Long-term debt As of March 31, 2014, the total carrying value and estimated fair value of our long-term debt, including the current portion, were $22.7 billion and $23.2 billion, respectively. This is compared to a carrying value and estimated fair value of $15.6 billion and $15.8 billion, respectively, as of June 30, 2013. These estimated fair values are based on Level 2 inputs. The components of our long-term debt, including the current portion, and the associated interest rates were as follows as of March 31, 2014: Stated Effective Interest Interest Due Date Face Value Rate Rate ------------------------------------------------------------------ - (In millions) Notes June 1, 2014 $ 2,000 2.950% 3.049% September 25, 2015 1,750 1.625% 1.795% February 8, 2016 750 2.500% 2.642% November 15, 2017 600 0.875% 1.084% May 1, 2018 450 1.000% 1.106% December 6, 2018 (a) 1,250 1.625% 1.824% June 1, 2019 1,000 4.200% 4.379% October 1, 2020 1,000 3.000% 3.137% February 8, 2021 500 4.000% 4.082% December 6, 2021 (b) 2,412 2.125% 2.233% November 15, 2022 750 2.125% 2.239% May 1, 2023 1,000 2.375% 2.465% December 15, 2023 (a) 1,500 3.625% 3.726% December 6, 2028 (b) 2,412 3.125% 3.218% May 2, 2033 (c) 758 2.625% 2.690% June 1, 2039 750 5.200% 5.240% October 1, 2040 1,000 4.500% 4.567% February 8, 2041 1,000 5.300% 5.361% November 15, 2042 900 3.500% 3.571% May 1, 2043 500 3.750% 3.829% December 15, 2043 (a) 500 4.875% 4.918% ------------------------------------ - Total $ 22,782 -- --------- - (a) In December 2013, we issued $3.3 billion of debt securities. (b) In December 2013, we issued €3.5 billion of debt securities. (c) In April 2013, we issued €550 million of debt securities. The notes in the table above are senior unsecured obligations and rank equally with our other senior unsecured debt outstanding. Interest on these notes is paid semi-annually, except for the euro-denominated debt securities on which interest is paid annually. As of March 31, 2014, the aggregate unamortized discount for our long-term debt, including the current portion, was $103 million. Credit facility We have a $5.0 billion credit facility that expires on November 14, 2018 which serves as a back-up for our commercial paper program. As of March 31, 2014, we were in compliance with the only financial covenant in the credit agreement, which requires us to maintain a coverage ratio of at least three times earnings before interest, taxes, depreciation, and amortization to interest expense, as defined in the credit agreement. No commercial paper was outstanding as of March 31, 2014 or June 30, 2013, and no amounts were drawn against the credit facility during any of the periods presented. 44 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Unearned Revenue Unearned revenue at March 31, 2014 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 coverage period and accounted for as subscriptions with revenue recognized ratably over the coverage period. Unearned revenue at March 31, 2014 also included payments for: post-delivery support and consulting services to be performed in the future; Xbox Live subscriptions and prepaid points; Office 365 Home subscriptions; Microsoft Dynamics business solutions products; Skype prepaid credits and subscriptions; OEM minimum commitments; and other offerings for which we have been paid in advance and earn the revenue when we provide the service or software, or otherwise meet the revenue recognition criteria. The following table outlines the expected future recognition of unearned revenue as of March 31, 2014: (In millions) -------------------------------- - Three Months Ending, June 30, 2014 $ 7,825 September 30, 2014 4,937 December 31, 2014 3,504 March 31, 2015 1,404 Thereafter 1,842 -------------------------------- - Total $ 19,512 - ------- - Share Repurchases During the three months ended March 31, 2014, we repurchased 47 million shares of Microsoft common stock for $1.8 billion under a $40.0 billion share repurchase program approved by our Board of Directors on September 16, 2013. The share repurchase program became effective on October 1, 2013, has no expiration date, and may be suspended or discontinued at any time without notice. As of March 31, 2014, approximately $36.2 billion remained of our $40.0 billion share repurchase program. All repurchases were made using cash resources. During the nine months ended March 31, 2014, we repurchased 147 million shares of Microsoft common stock for $5.3 billion under both the $40.0 billion share repurchase program approved by our Board of Directors on September 16, 2013, and the share repurchase program that was announced in September 2008 and expired September 30, 2013. All repurchases were made using cash resources. 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 2014 September 16, 2013 $ 0.28 November 21, 2013 $ 2,332 December 12, 2013 November 19, 2013 $ 0.28 February 20, 2014 $ 2,322 March 13, 2014 March 11, 2014 $ 0.28 May 15, 2014 $ 2,313 June 12, 2014------------------------------------------------------------------------------------------------------------------------- - Fiscal Year 2013 September 18, 2012 $ 0.23 November 15, 2012 $ 1,933 December 13, 2012 November 28, 2012 $ 0.23 February 21, 2013 $ 1,925 March 14, 2013 March 11, 2013 $ 0.23 May 16, 2013 $ 1,921 June 13, 2013------------------------------------------------------------------------------------------------------------------------- - 45 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 Off-Balance Sheet Arrangements We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. In evaluating estimated losses on these indemnifications, we consider factors such as the degree of probability of an unfavorable outcome and our ability to make a reasonable estimate of the amount of loss. These obligations did not have a material impact on our financial statements during the periods presented. Other Planned Uses of Capital On September 2, 2013, we announced that we entered into a definitive agreement to acquire substantially all of Nokia's Devices and Services business, license Nokia's patents, and license and use Nokia's mapping services (the "Agreement"). Under the terms of the Agreement, we agreed to pay €3.79 billion (approximately $5.0 billion) to purchase substantially all of Nokia's Devices and Services business, and €1.65 billion (approximately $2.2 billion) to license Nokia's patents, for a total transaction price of €5.44 billion (approximately $7.2 billion) in cash. We intend to draw upon our overseas cash resources to fund the acquisition. In connection with the Agreement, on September 23, 2013, we provided Nokia €1.5 billion ($2.0 billion) of financing in the form of convertible notes, which are included in short-term investments on our balance sheet. Nokia will repay these notes from the proceeds of the acquisition upon closing. Nokia's shareholders approved the Agreement on November 19, 2013. We expect the acquisition will close on April 25, 2014. 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, datacenters, and computer systems for research and development, sales and marketing, support, and administrative staff. We expect capital expenditures to increase in coming years in support of our cloud and devices strategy. 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 through debt or equity issuances. These alternatives could result in higher effective tax rates, increased interest expense, or dilution of our earnings. We have borrowed funds and continue to believe we have the ability to do so at reasonable interest rates. RECENT ACCOUNTING GUIDANCE Recently Adopted Accounting Guidance In December 2011, the Financial Accounting Standards Board ("FASB") issued guidance enhancing disclosure requirements about the nature of an entity's right to offset and related arrangements associated with its financial 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. In January 2013, the FASB clarified that the scope of this guidance applies to derivatives, repurchase agreements, and securities lending arrangements that are either offset or subject to an enforceable master netting arrangement, or similar agreements. We adopted this new guidance beginning July 1, 2013. Adoption of this new guidance resulted only in changes to the presentation of Note 5 - Derivatives in the Notes to Financial Statements. 46 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 In February 2013, the FASB issued guidance on disclosure requirements for items reclassified out of AOCI. This new guidance requires entities to present (either on the face of the income statement or in the notes to financial statements) the effects on the line items of the income statement for amounts reclassified out of AOCI. We adopted this new guidance beginning July 1, 2013. Adoption of this new guidance resulted only in changes to the presentation of Note 15 - Accumulated Other Comprehensive Income in the Notes to Financial Statements. Recent Accounting Guidance Not Yet Adopted In March 2013, the FASB issued guidance on a parent's accounting for the cumulative translation adjustment upon derecognition of a subsidiary or group of assets within a foreign entity. This new guidance requires that the parent release any related cumulative translation adjustment into net income only if the sale or transfer results in the complete or substantially complete liquidation of the foreign entity in which the subsidiary or group of assets had resided. The new guidance will be effective for us beginning July 1, 2014. 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 inventories. Revenue Recognition Revenue recognition requires judgment, including whether a software arrangement includes multiple elements, and if so, whether the 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 the 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. Certain volume licensing arrangements include a perpetual license for current products combined with rights to receive unspecified future versions of software products ("Software Assurance") and are accounted for as subscriptions, with billings recorded as unearned revenue and recognized as revenue ratably over the coverage period. Software updates are evaluated on a case-by-case basis to determine whether they meet the definition of an upgrade, which may require revenue to be deferred and recognized when the upgrade is delivered, or if it is determined that implied post-contract customer support ("PCS") is being provided, revenue from the arrangement is deferred and recognized over the implied PCS term. If updates are determined to not meet the definition of an upgrade, revenue is generally recognized as products are shipped or made available. Windows 7 revenue was subject to deferral as a result of the Windows Upgrade Offer, which started June 2, 2012. The offer provided significantly discounted rights to purchase Windows 8 Pro to qualifying end-users that purchased Windows 7 PCs during the eligibility period. Microsoft was responsible for delivering Windows 8 Pro to the end customer. Accordingly, revenue related to the allocated discount for undelivered Windows 8 was deferred until it was delivered or the redemption period expired. Microsoft Office system revenue was subject to deferral as a result of the Office Upgrade Offer, which started October 19, 2012. The Office Upgrade Offer allowed customers who purchased qualifying 2010 Microsoft Office system or Office for Mac 2011 products to receive, at no cost, a one-year subscription to Office 365 Home or the equivalent version of 2013 Microsoft Office system upon general availability. Small business customers in applicable markets were also eligible for a three-month trial of Office 365 Small Business Premium. Accordingly, estimated revenue related to the undelivered 2013 Microsoft Office system and subscription services was deferred until the products and services were delivered or the redemption period expired. Impairment of Investment Securities We review investments quarterly for indicators of other-than-temporary impairment. This determination requires significant judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an 47 -------------------------------------------------------------------------------- Table of Contents PART I Item 2 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 primarily through the use of a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital. The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit. Research and Development Costs Costs incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, all software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to manufacturing. The amortization of these costs is included in cost of revenue over the estimated life of the products. Legal and Other Contingencies The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency such as a legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. Disclosure of a contingency is required if there is at least a reasonable possibility that a loss has been incurred. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our financial statements. Income Taxes The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity's financial statements or tax returns. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon 48 -------------------------------------------------------------------------------- Table of Contents PART I Item 2, 3 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. Inventories Inventories are stated at average cost, subject to the lower of cost or market. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. These reviews include analysis of demand forecasts, product life cycle status, product development plans, current sales levels, pricing strategy, and component cost trends. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. The determination of market value and the estimated volume of demand used in the lower of cost or market analysis require significant judgment. |