Accounting Policies
Stock Split
Accounting Changes
Unearned Revenue
Cash and Short-Term Investments
Inventories
Property and Equipment
Equity and Other Investments
Goodwill
Intangible Assets
Derivatives
Investment Income/(Loss)
Income Taxes
Stockholders’ Equity
Other Comprehensive Income
Employee Stock and Savings Plans
Earnings Per Share
Acquisitions
Commitments and Guarantees
Contingencies
Segment Information
Note 1—Accounting Policies
Accounting Principles
The financial statements and
accompanying notes are prepared in accordance with accounting principles
generally accepted in the United
States of America.
Principles of Consolidation
The financial statements include the
accounts of Microsoft Corporation and its subsidiaries (Microsoft).
Intercompany transactions and balances have been eliminated. Equity investments
in which we own at least 20% of the voting securities are accounted for using
the equity method, except for investments in which the Company is not able to
exercise significant influence over the investee, in which case, the cost
method of accounting is used.
Estimates and Assumptions
Preparing financial statements
requires management to make estimates and assumptions that affect the reported
amounts of assets, liabilities, revenue, and expenses. Examples include
estimates of loss contingencies and product life cycles, and assumptions such
as the elements comprising a software arrangement, including the distinction
between upgrade/enhancements and new products; when technological feasibility
is achieved for our products; the potential outcome of future tax consequences
of events that have been recognized in our financial statements or tax returns;
and determining when investment impairments are other-than-temporary. Actual
results and outcomes may differ from management’s estimates and assumptions.
Foreign Currencies
Assets and liabilities recorded in
foreign currencies are translated at the exchange rate on the balance sheet
date. Revenue and expenses are translated at average rates of exchange
prevailing during the year. Translation adjustments resulting from this process
are charged or credited to other comprehensive income (OCI).
Revenue Recognition
Revenue for retail packaged products,
products licensed to original equipment manufacturers (OEMs), and perpetual
licenses for current products under our Open and Select volume licensing
programs is generally recognized as products are shipped, with a portion of the
revenue recorded as unearned due to undelivered elements including, in some
cases, free post-delivery telephone support and the right to receive
unspecified upgrades/enhancements of Microsoft Internet Explorer on a
when-and-if-available basis. The amount of revenue allocated to undelivered
elements is based on the sales price of those elements when sold separately
(vendor-specific objective evidence) using the residual method. Under the
residual method, the total fair value of the undelivered elements, as indicated
by vendor-specific objective evidence, is recorded as unearned, and the
difference between the total arrangement fee and the amount recorded as
unearned for the undelivered elements is recognized as revenue related to
delivered elements. Unearned revenue due to undelivered elements is recognized
ratably on a straight-line basis over the related product’s life cycle, which
is currently estimated at three and a half years for Windows operating systems
and two years for desktop applications (primarily Office).
Revenue from multi-year licensing
arrangements are accounted for as subscriptions, with billings recorded as
unearned revenue and recognized as revenue ratably over the billing coverage
period. Certain multi-year licensing arrangements include rights to receive
future versions of software product on a when-and-if-available basis under Open
and Select volume licensing programs (currently named Software Assurance and,
previously, Upgrade Advantage). In addition, other multi-year licensing
arrangements include a perpetual license for current products combined with
rights to receive future versions of software products on a
when-and-if-available basis under Open, Select, and Enterprise Agreement volume
licensing programs. MSN Internet Access
subscriptions, Microsoft bCentral subscriptions, and Microsoft Developer
Network subscriptions are also accounted for as subscriptions.
Revenue related to our Xbox game
console is recognized upon shipment of the product to retailers. Online advertising
revenue is recognized as advertisements are displayed. Consulting services
revenue is recognized as services are rendered, generally based on the
negotiated hourly rate in the consulting arrangement and the number of hours
worked during the period.
Costs related to insignificant
obligations, which include telephone support for developer tools software, PC
games, computer hardware, and Xbox, are accrued when the related revenue is
recognized. Provisions are recorded for estimated returns, concessions, and bad
debts.
Cost of Revenue
Cost of revenue includes
manufacturing and distribution costs for products and programs sold, operation
costs related to product support service centers and product distribution
centers, costs incurred to support and maintain Internet-based products and
services, and costs associated with the delivery of consulting services.
Research and Development
Research and development expenses
include payroll, employee benefits, and other headcount-related costs associated
with product development. Technological feasibility for our software products
is reached shortly before the products are released to manufacturing. Costs
incurred after technological feasibility is established are not material, and
accordingly, we expense all research and development costs when incurred.
Sales and Marketing
Sales and marketing expenses include
payroll, employee benefits, and other headcount-related costs as well as
expenses related to advertising, promotions, tradeshows, seminars, and other
programs. Advertising costs are expensed as incurred. Advertising expense was
$1.02 billion in 2001, $1.13 billion in 2002, and $1.06 billion in 2003.
Income Taxes
Income tax expense includes U.S. and international income taxes, plus the provision
for U.S.
taxes on undistributed earnings of international subsidiaries not deemed to be
permanently invested. Certain items of income and expense are not reported in
tax returns and financial statements in the same year. The tax effect of such
temporary differences is reported as deferred income taxes.
Financial Instruments
We consider all highly liquid
interest-earning investments with a maturity of three months or less at the
date of purchase to be cash equivalents. Short-term investments generally
mature between three months to nine years from the purchase date. Investments
with maturities beyond one year may be classified as short-term based on their
highly liquid nature and because such marketable securities represent the
investment of cash that is available for current operations. All cash and
short-term investments are classified as available for sale and are recorded at
market value using the specific identification method; unrealized gains and
losses are reflected in OCI.
Equity and other investments include
debt and equity instruments. Debt securities and publicly traded equity
securities are classified as available for sale and are recorded at market
using the specific identification method. Unrealized gains and losses
(excluding other-than-temporary impairments) are reflected in OCI. All other
investments, excluding those accounted for using the equity method, are
recorded at cost.
We lend certain fixed income and
equity securities to enhance investment income. Collateral and/or security
interest is determined based upon the underlying security and the
creditworthiness of the borrower. The fair value of collateral that we are
permitted to sell or repledge was $499 million at both June 30, 2002 and 2003.
Investments are considered to be
impaired when a decline in fair value is judged to be other-than-temporary. We
employ a systematic methodology that considers available 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,
the duration and extent to which the fair value is less than cost, as well as
our intent and ability to hold the investment. 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,
operational and financing cash flow factors, and rating agency actions. Once a
decline in fair value is determined to be other-than-temporary, an impairment
charge is recorded and a new cost basis in the investment is established.
We use derivative instruments to
manage exposures to foreign currency, security price, interest rate, and credit
risks. Our objectives for holding derivatives include reducing, eliminating,
and efficiently managing the impact of these exposures as effectively as
possible.
Foreign Currency Risk. Certain
forecasted transactions and assets are exposed to foreign currency risk. We
monitor our foreign currency exposures daily to maximize the overall
effectiveness of our foreign currency hedge positions. Principal currencies
hedged include the Euro, Japanese yen, British pound, and Canadian dollar. Non
U.S. dollar denominated securities are hedged using foreign exchange forward
contracts that are designated as fair value hedging instruments under SFAS 133.
Options used to hedge a portion of forecasted international revenue for up to
three years in the future are designated as cash flow hedging instruments.
Certain options and forwards not designated as hedging instruments under SFAS
133 are also used to hedge the impact of the variability in exchange rates on
accounts receivable and collections denominated in certain foreign currencies.
Securities Price Risk. Strategic
equity investments are subject to market price risk. From time to time, we use
and designate options to hedge fair values and cash flows on certain equity
securities. We determine the security, or forecasted sale thereof, selected for
hedging by market conditions, up-front costs, and other relevant factors. Once
established, the hedges are not dynamically managed or traded, and are
generally not removed until maturity.
Interest Rate Risk. Fixed-income
securities are subject to interest rate risk. The fixed-income portfolio is
diversified and consists primarily of investment grade securities to minimize
credit risk. We use exchange-traded option and future contracts, not designated
as hedging instruments under SFAS 133, to hedge interest rate risk. In
addition, we routinely use options, not designated as hedging instruments under
SFAS 133, to hedge our exposure to interest rate risk in the event of a
catastrophic increase in interest rates.
Other Derivatives. Swap
contracts, not designated as hedging instruments under SFAS 133, are used to
manage exposures to credit risks. In addition, we may invest in warrants to
purchase securities of other companies as a strategic investment. Warrants that
can be net share settled are deemed derivative financial instruments and are
not designated as hedging instruments. To Be Announced forward purchase
commitments of mortgage-backed assets are also considered derivatives in cases
where physical delivery of the assets are not taken at the earliest available delivery
date.
For options designated either as fair
value or cash flow hedges, changes in the time value are excluded from the
assessment of hedge effectiveness.
Allowance for Doubtful Accounts
The allowance for doubtful accounts
reflects our best estimate of probable losses inherent in the account
receivable balance. We determine the allowance based on known troubled
accounts, historical experience, and other currently available evidence.
Activity in the allowance for doubtful accounts is as follows:
(In
millions)
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|
|
|
|
|
|
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Year Ended June 30
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Balance at
beginning of period
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Charged to costs
and expenses
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Write-offs and other
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Balance at
end of period
|
2001
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$ 186
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|
$ 157
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|
$ 169
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|
$ 174
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2002
|
174
|
|
192
|
|
157
|
|
209
|
2003
|
209
|
|
118
|
|
85
|
|
242
|
Inventories
Inventories are stated at the lower of cost or market, using
the average cost method. Cost includes materials, labor, and manufacturing
overhead related to the purchase and production of inventories.
Property and Equipment
Property and equipment is stated at
cost and depreciated using the straight-line method over the shorter of the
estimated life of the asset or the lease term, ranging from one to 15 years.
Computer software developed or obtained for internal use is depreciated using
the straight-line method over the estimated useful life of the software,
generally three years or less.
Goodwill
Beginning in fiscal 2002 with the
adoption of SFAS 142, Goodwill and Other Intangible Assets, goodwill is
no longer amortized, but instead tested for impairment at least annually. Prior
to fiscal 2002, goodwill was amortized using the straight-line method over its
estimated period of benefit.
Intangible Assets
Intangible assets are amortized using
the straight-line method over their estimated period of benefit, ranging from
one to ten years. We periodically evaluate the recoverability of intangible
assets and take into account events or circumstances that warrant revised
estimates of useful lives or that indicate that an impairment exists. All of
our intangible assets are subject to amortization.
Employee Stock Plans
We follow Accounting Principles Board
Opinion 25, Accounting for Stock Issued to Employees, to account for
stock option and employee stock purchase plans, which generally does not
require income statement recognition of options granted at the market price on
the date of issuance. However, certain events, such as the accelerated vesting
of options and the exchange of options in a business combination, can trigger
recording an expense. In addition to announcing changes to our employee
compensation arrangements in July 2003, we also indicated that we will adopt
the fair value recognition provisions of SFAS 123, Accounting for Stock-Based
Compensation, effective July 1, 2003 and will report that change in accounting
principle using the retroactive restatement method described in SFAS 148, Accounting
for Stock-Based Compensation – Transition and Disclosure.
The following table illustrates the
effect on net income and earnings per share as if we had applied the fair value
recognition provisions of SFAS 123:
(In
millions, except earnings per share)
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|
|
|
|
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Year Ended June 30
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2001
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2002
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2003
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|
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Net income, as reported
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$ 7,346
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$ 7,829
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$ 9,993
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Add: Stock-based employee compensation expense included in
reported net income, net of tax
|
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144
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|
99
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52
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Deduct: Total stock-based employee compensation expense
determined under fair value based method for all awards, net of tax
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(2,406)
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(2,573)
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(2,514)
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Pro forma net income
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$ 5,084
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$ 5,355
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$ 7,531
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Earnings per share:
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Basic – as reported
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$ 0.69
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$ 0.72
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$
0.93
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Basic – pro forma
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$ 0.48
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$ 0.50
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$
0.70
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Diluted – as reported
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$ 0.66
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$ 0.70
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$
0.92
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Diluted – pro forma
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$ 0.46
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|
$ 0.48
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$
0.69
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