MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS FOR FISCAL YEARS 2008, 2007, AND 2006
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 financial statements and the accompanying notes to the financial statements (“Notes”).
We generate revenue by developing, manufacturing, licensing, and supporting a wide range of software products and services for many different types of computing devices. Our software products and services include operating systems for servers, personal computers, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutions applications; high-performance computing applications; software development tools; and video games. We provide consulting and product support services, and we train and certify computer system integrators and developers. We also design and sell hardware including the Xbox 360 video game console, the Zune digital music and entertainment device, and peripherals. Online offerings and information are delivered through Live Search, Windows Live, Office Live, our MSN portals and channels, and the Microsoft Online Services platform which includes offerings for businesses such as Microsoft Dynamics CRM Online, Exchange Hosted Services, Exchange Online, and SharePoint Online. We enable the delivery of online advertising across our broad range of digital media properties and on Live Search through our proprietary adCenter® platform.
Our revenue historically has fluctuated quarterly and has generally been the highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers. Our Entertainment and Devices Division is particularly seasonal as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Typically, the Entertainment and Devices Division has generated over 40% of its yearly segment revenues in our second fiscal quarter. In fiscal year 2007, our revenue was highest in the third quarter due to the recognition of $1.7 billion of revenue previously deferred from the Express Upgrade to Windows Vista and Microsoft Office Technology Guarantee programs and pre-shipments of Windows Vista and the 2007 Microsoft Office system. The technology guarantee programs provided customers who purchased current products with free or discounted rights to Windows Vista and the 2007 Microsoft Office system when those products became available to consumers.
We intend to sustain the long-term growth of our businesses through technological innovation, engineering excellence, and a commitment to delivering high-quality products and services to customers and partners. Recognizing that one of our primary challenges is to help accelerate worldwide PC adoption and software upgrades, we continue to advance the functionality, security, and value of Windows operating systems and to develop operating system versions targeted at emerging markets. We also are increasing our focus on selling our products in emerging markets and reducing the amount of unlicensed software used in those markets. In addition, we continue to develop innovative software applications and solutions that we believe will enhance the productivity of information workers, improve communication and collaboration in work groups, aid business intelligence, and streamline processes for small and mid-sized businesses. To sustain the growth of our Server and Tools business amid competition from other vendors of proprietary and open source software, our goal is to deliver products that provide the best platform for network computing—software that is easiest to deploy and manage, and that is most secure—with the lowest total cost of ownership.
We continue to invest in research and development in existing and new lines of business, including online solutions, business solutions, mobile computing, communication, entertainment, and other areas that we believe may contribute to our long-term growth. We also invest in research and development of advanced technologies for future software products. We believe that delivering innovative and high-value solutions through our integrated platform is the key to meeting customer needs and to our future growth.
We believe that over the last few years we have laid a foundation for long-term growth by delivering innovative products, creating opportunities for partners, improving customer satisfaction with key audiences, and improving our internal business processes. Our focus in fiscal year 2009 is to continue to build on this foundation and to continue to execute well in key areas, including continuing to innovate on our integrated software platform, responding effectively to customer and partner needs, and continuing to focus internally on product excellence, business efficacy, and accountability across the company.
Key market opportunities include:
Consumer technology. We are focused on delivering consumer software products that we believe are compelling in terms of design, features, and functionality. We also are working to define the next era of consumer electronics through the development of innovative software that runs on a wide range of devices and connects people quickly and easily to the information, experiences, and communities they care about.
Software plus services. The ability to combine the power of desktop and server software with the reach of the Internet represents an opportunity across every one of our businesses. We believe our software plus services approach will enable us to deliver new experiences to end users and new value to businesses.
Expanding our presence on the desktop, the server, and with developers. Through our ability to deliver additional value in security, messaging, systems management, and collaboration, and new technology for high-performance computing, unified communications, and business intelligence, we believe we are well-positioned to build on our strength with businesses of all sizes and with developers. Fiscal year 2008 saw widespread adoption of Windows Vista and the 2007 Microsoft Office system and the launch of Windows Server 2008, SQL Server 2008, and Visual Studio 2008.
| (In millions, except percentages) | 2008 | 2007 | 2006 | Percentage Change 2008 versus 2007 |
Percentage Change 2007 versus 2006 |
|---|---|---|---|---|---|
| Revenue | $60,420 | $51,122 | $44,282 | 18% | 15% |
| Operating income | $22,492 | $18,524 | $16,472 | 21% | 12% |
| Diluted earnings per share | $ 1.87 | $ 1.42 | $ 1.20 | 32% | 18% |
Fiscal year 2008 compared with fiscal year 2007
Revenue growth was driven primarily by increased licensing of the 2007 Microsoft Office system, increased Xbox 360 platform sales, increased revenue associated with Windows Server and SQL Server, and increased licensing of Windows Vista. Foreign currency exchange rates accounted for a $1.6 billion or three percentage point increase in revenue during the year.
Operating income increased primarily reflecting increased revenue, partially offset by increased headcount-related expenses, increased costs for legal settlements and legal contingencies, and increased cost of revenue. Headcount-related expenses increased 12%, reflecting an increase in headcount during the year. We incurred $1.8 billion of legal charges during the year primarily related to the European Commission fine of $1.4 billion (€899 million) as compared with $511 million of legal charges during the prior year. Cost of revenue increased $905 million or 8%, reflecting increased data center and equipment costs, online content expenses, and increased costs associated with the growth in our consulting services, partially offset by decreased Xbox 360 costs. The decreased Xbox 360 costs reflect the $1.1 billion charge in fiscal year 2007 related to the expansion of our Xbox 360 warranty coverage as discussed below, partially offset by increased Xbox 360 product costs reflecting growth in unit console sales.
The diluted earnings per share growth was impacted by the $1.1 billion Xbox 360 charge in fiscal year 2007 and current year share repurchases.
Fiscal year 2007 compared with fiscal year 2006
Revenue growth was driven primarily by licensing of the 2007 Microsoft Office system and Windows Vista, increased revenue associated with SQL Server, Windows Server, and Visual Studio, and increased Xbox 360 platform sales. Foreign currency exchange rates did not have a significant impact on consolidated revenue during the year.
Operating income growth was driven primarily by increased revenue and decreased costs for legal settlements and legal contingencies, partially offset by increased cost of revenue associated with Xbox 360 and Windows Vista, increased OSB data centers costs, and increased sales and marketing expenses. In July 2007, we expanded our global Xbox 360 warranty coverage to three years from the date of purchase for a general hardware failure indicated by three flashing red lights. As a result, we recorded a $1.1 billion charge in fiscal year 2007 for anticipated costs under the warranty policy, inventory write-downs, and product returns. The increase in sales and marketing expenses was primarily driven by increased headcount-related expenses and marketing costs related to product launches. Headcount-related expenses increased 18%, driven by an increase in headcount during the year.
Fiscal Year 2009 Outlook
Global macroeconomic factors have a strong correlation to demand for our software, services, hardware, and online offerings. In fiscal year 2009, we expect a broad continuation of the economic conditions and demand we experienced during the latter part of fiscal year 2008. In fiscal year 2009, we expect double digit revenue growth and we estimate PC shipments will grow between 12% and 14%. Within the overall PC market, we expect current trends to continue with consumer segment growth exceeding that of the business segment and emerging market growth exceeding that of mature markets.
SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS)
The revenue and operating income (loss) amounts in this section are presented on a basis consistent with U.S. Generally Accepted Accounting Principles (“GAAP”) and include certain reconciling items attributable to each of the segments. The segment information appearing in Note 19—Segment Information of the Notes to Financial Statements is presented on a basis consistent with the Company’s internal management reporting, in accordance with Statement of Financial Accounting Standards (SFAS) No. 131, Disclosures about Segments of an Enterprise and Related Information. Certain corporate-level activity has been excluded from our segment operating results and is presented separately. Prior period amounts have been recast to conform to the way we internally manage and monitor performance at the segment level during the current period.
Client
| (In millions, except percentages) | 2008 | 2007 | 2006 | Percentage Change 2008 versus 2007 |
Percentage Change 2007 versus 2006 |
|---|---|---|---|---|---|
| Revenue | $16,865 | $14,976 | $13,107 | 13% | 14% |
| Operating income | $13,052 | $11,467 | $10,208 | 14% | 12% |
Client offerings consist of premium and standard edition Windows operating systems. Premium editions are those that include additional functionality and are sold at a price above our standard editions. Premium editions include Windows Vista Business, Windows Vista Home Premium, Windows Vista Ultimate, Windows Vista Enterprise, Windows XP Professional, Windows XP Media Center Edition, and Windows XP Tablet PC Edition. Standard editions include Windows Vista Home Basic and Windows XP Home. Client revenue growth generally correlates with the growth of PC purchases from OEMs that pre-install versions of Windows operating systems because the OEM channel accounts for over 80% of total Client revenue. The differences between unit growth rates and revenue growth rates from year to year are affected by changes in the mix of OEM Windows operating systems licensed with premium edition operating systems as a percentage of total OEM Windows operating systems licensed (“OEM premium mix”), changes in the geographical mix, and changes in the channel mix of products sold by large, multi-national OEMs versus those sold by local and regional system builders.
Fiscal year 2008 compared with fiscal year 2007
Client revenue increased reflecting growth in licensing of Windows Vista. By the end of fiscal year 2008, more than 180 million Windows Vista licenses had been sold (approximately 130 million were sold during fiscal year 2008) and millions of enterprise seats had been deployed. OEM revenue increased $1.7 billion or 13%, driven by 16% growth in OEM license units. Revenue from commercial and retail licensing of Windows operating systems increased $209 million or 8%, primarily from Enterprise Agreements and anti-piracy efforts in emerging markets. During the year, the OEM premium mix increased seven percentage points to 74%, reflecting strong demand for Windows Vista Home Premium. Based on our estimates, total worldwide PC shipments from all sources grew approximately 12% to 14%, driven by demand in both emerging and mature markets.
Client operating income increased reflecting increased revenue, partially offset by increased sales and marketing expenses and cost of revenue. Sales and marketing expenses increased $149 million or 10%, primarily reflecting increased expenses associated with our corporate sales force. Cost of revenue increased $115 million or 13%, primarily driven by Windows Vista product costs.
Fiscal year 2007 compared with fiscal year 2006
Client revenue increased primarily reflecting licensing of Windows Vista. OEM revenue increased $1.4 billion or 13% driven by 13% growth in OEM license units while revenue from commercial and retail licensing of Windows operating systems increased $447 million or 22%. During the year, the OEM premium mix increased 15 percentage points to 67%. We estimate total worldwide PC shipments from all sources grew 10% to 12% driven by demand in both emerging and mature markets.
Client operating income increased reflecting the increased revenue and decreased research and development costs, partially offset by increased Windows Vista product costs and sales and marketing expenses for launch-related programs. The decrease in research and development expenses reflected the capitalization of certain Windows Vista software development costs and completion of product development on Windows Vista. Headcount-related expenses decreased 7%, primarily driven by a decrease in headcount during the year.
Fiscal Year 2009 Outlook
We expect PC market growth will exceed Client revenue growth. We believe PC unit growth rates will be higher in the consumer segment than in the business segment and higher in emerging markets than in mature markets.
Server and Tools
| (In millions, except percentages) | 2008 | 2007 | 2006 | Percentage Change 2008 versus 2007 |
Percentage Change 2007 versus 2006 |
|---|---|---|---|---|---|
| Revenue | $13,170 | $11,171 | $9,665 | 18% | 16% |
| Operating income | $ 4,593 | $ 3,643 | $2,868 | 26% | 27% |
Server and Tools concentrates on licensing products, applications, tools, content, and services that make information technology professionals and developers more productive and efficient. Server and Tools offerings consist of server software licenses and client access licenses (“CAL”) for Windows Server, Microsoft SQL Server, and other server products. We also offer developer tools, training, certification, Microsoft Press, Premier and Professional product support services, and Microsoft Consulting Services. Server products can be run on-site, in a hosted environment, or in a Web-based environment. We use multiple channels for licensing, including pre-installed OEM versions, licenses through partners, and licenses directly to end customers. We sell licenses both as one-time licenses and as multi-year volume licenses.
Fiscal year 2008 compared with fiscal year 2007
Server and Tools revenue increased reflecting growth in product and services revenue and included a favorable impact from foreign currency exchange rates of $464 million or four percentage points. Server and server application revenue (including CAL revenue) and developer tools revenue increased $1.4 billion or 15%, primarily driven by growth in volume licensing of Windows Server and SQL Server products. This growth reflects broad adoption of the Windows Platform and applications with the releases of Windows Server 2008 and Visual Studio 2008 during the fiscal year. Consulting and Premier and Professional product support services revenue increased $593 million or 29%, primarily due to higher demand for consulting and support services by corporate enterprises.
Server and Tools operating income increased primarily due to growth in high-margin product revenue, partially offset by increased sales and marketing expenses, cost of revenue, and research and development expenses. Sales and marketing expenses increased $475 million or 14%, due to higher expenses associated with our corporate sales force. Cost of revenue increased $394 million or 18%, reflecting the growth in Consulting and Premier and Professional product support services. Research and development expenses increased $183 million or 11%, primarily driven by increased headcount-related expenses. Headcount-related expenses increased 8%, driven by an increase in headcount during the year.
Fiscal year 2007 compared with fiscal year 2006
Server and server application revenue (including CAL revenue) and developer tools, training, and certification revenue increased $1.1 billion or 13%, and included a favorable impact from foreign currency exchange rates of $168 million or two percentage points. The increase in server and server application revenue was primarily driven by increased revenue associated with SQL Server, Windows Server, and Visual Studio. The results reflect broad adoption of Windows Server products, especially SQL Server which grew over 20%. Consulting and Premier and Professional product support services revenue increased $428 million or 26%, primarily due to higher demand for Premier services by corporate enterprises.
Server and Tools operating income increased reflecting the increased revenue, partially offset by growth in headcount-related expenses and cost of revenue for services. Headcount-related expenses increased 14%, driven by an increase in headcount during the year. Cost of revenue increased $260 million or 14%, reflecting growth in Consulting and Premier and Professional product support services.
Fiscal Year 2009 Outlook
We expect continued growth in both product and services revenue driven by strong customer demand for the recently released Windows Server 2008 and Visual Studio 2008 and upcoming release of SQL Server 2008.
Online Services Business
| (In millions, except percentages) | 2008 | 2007 | 2006 | Percentage Change 2008 versus 2007 |
Percentage Change 2007 versus 2006 |
|---|---|---|---|---|---|
| Revenue | $ 3,214 | $2,441 | $2,296 | 32% | 6% |
| Operating income (loss) | $(1,233) | $(617) | $ 5 | (100)% | * |
* Not meaningful
Online Services Business (“OSB”) consists of an on-line advertising platform with offerings for both publishers and advertisers, personal communications services such as email and instant messaging, online information offerings such as Live Search, and the MSN portals and channels around the world. We earn revenue primarily from online advertising, including search, display, and email and messaging services. Revenue is also generated through subscriptions and transactions generated from online paid services, from advertiser and publisher tools, digital marketing and advertising agency services, and from MSN narrowband Internet access subscribers. We continue to launch new online offerings and expect to do so in the future. During fiscal year 2008, we launched new releases of Windows Live Search, the Windows Live suite of applications and services, and updated our MSN Video Service. In addition, we launched a new release of adCenter and expanded our advertising platform portfolio.
During the first quarter of fiscal year 2008, we completed our acquisition of aQuantive, Inc. (“aQuantive”), a digital marketing business which we expect will play a key role in the development of our advertising business. aQuantive earns revenue from online advertising and from digital marketing and advertising agency services. We believe the acquisition will help us build and support next-generation advertiser and publisher solutions in environments such as cross-media planning, video-on-demand, and Internet protocol television. aQuantive was consolidated into our results of operations starting August 10, 2007, the acquisition date.
Proposed Acquisition of Yahoo! Inc.
To accelerate our advertising strategy, during fiscal year 2008 we submitted a proposal to the Yahoo! Inc. board of directors to acquire all of the outstanding shares of Yahoo!. After careful consideration, we determined that the price demanded by Yahoo! was not in the best interest of our shareholders and we withdrew our proposal to acquire the company. Subsequently, we submitted several proposals to purchase Yahoo!’s search business and make an investment in Yahoo!, all of which were rejected by Yahoo!. We continue to invest heavily in new tools, Web experiences, improved search performance, and advertiser satisfaction, and we will continue to seek to build our scale through organic growth, partnerships, and strategic acquisitions.
Fiscal year 2008 compared with fiscal year 2007
OSB revenue increased driven by increased online advertising revenue and the inclusion of aQuantive revenue, partially offset by decreased access revenue. Online advertising revenue increased $553 million or 31%, to $2.3 billion. This increase reflects growth in our existing online advertising business and includes aQuantive online advertising revenue of $161 million. Agency revenue, which is solely derived from aQuantive, was $345 million during the year. Access revenue decreased $98 million or 28%, to $256 million, reflecting migration of subscribers to broadband or other competitively-priced service providers. As of June 30, 2008, we estimate we had approximately 460 million Windows Live IDs compared with 382 million as of the same date last year.
OSB operating loss increased driven by increased cost of revenue and other operating expenses, partially offset by increased revenue. Cost of revenue increased $796 million or 71%, primarily driven by increased data center and equipment costs, online content expenses, and aQuantive-related expenses. Sales and marketing expenses increased $300 million or 35%, primarily due to increased amortization of customer-related intangible assets of $94 million, increased headcount-related expenses, and increased marketing costs. Research and development expenses increased $177 million or 18%, and general and administrative expenses increased $117 million or 175%, primarily reflecting increased headcount-related expenses and merger and acquisition-related expenses. Headcount-related expenses increased 24%, driven by an increase in headcount during the year.
Fiscal year 2007 compared with fiscal year 2006
OSB revenue increased driven primarily by advertising revenue which grew $283 million or 19%, to $1.8 billion. This increase was primarily due to growth in advertising for search, home page, email, and messaging services. The increase in advertising revenue was partially offset by a $156 million or 31% decrease in access revenue.
OSB operating loss increased driven primarily by increased cost of revenue which grew $336 million or 42%, and increased headcount-related expenses as a result of continued search and advertising platform investments. The increase in cost of revenue was primarily driven by increased data center costs, online content expenses, and royalties. Headcount-related expenses increased 31%, driven by an increase in headcount during the year.
Fiscal Year 2009 Outlook
We expect revenue, including advertising revenue, to increase in fiscal year 2009 as we begin to see returns from investments we have made, including our acquisition of aQuantive. We also expect operating expenses to increase as we continue to invest in our long-term strategy.
Microsoft Business Division
| (In millions, except percentages) | 2008 | 2007 | 2006 | Percentage Change 2008 versus 2007 |
Percentage Change 2007 versus 2006 |
|---|---|---|---|---|---|
| Revenue | $18,932 | $16,402 | $14,465 | 15% | 13% |
| Operating income | $12,358 | $10,777 | $ 9,534 | 15% | 13% |
Microsoft Business Division (“MBD”) offerings consist of the Microsoft Office system and Microsoft Dynamics business solutions. Microsoft Office system products are designed to increase personal, team, and organization productivity through a range of programs, services, and software solutions. Growth of revenue from the Microsoft Office system offerings, which generate over 90% of MBD revenue, depends on our ability to add value to the core Office product set and to continue to expand our product offerings in other information worker areas such as enterprise content management, collaboration, unified communications, and business intelligence. Microsoft Dynamics products provide business solutions for financial management, customer relationship management, supply chain management, and analytics applications for small and mid-size businesses, large organizations, and divisions of global enterprises. We evaluate our results based upon the nature of the end user in two primary parts: business revenue, which includes Microsoft Office system revenue generated through volume licensing agreements and Microsoft Dynamics revenue, and consumer revenue, which includes revenue from retail packaged product sales and OEM revenue. In April 2008, we completed our acquisition of Fast Search & Transfer ASA (FAST), an enterprise search company. We believe the acquisition will broaden our enterprise search technology product offerings to businesses and will enable innovations in related areas such as our portal and content management.
Fiscal year 2008 compared with fiscal year 2007
MBD revenue increased reflecting growth in licensing of the 2007 Microsoft Office system and included a favorable impact from foreign currency exchange rates of $724 million or four percentage points. Business revenue increased $2.6 billion or 21%, primarily as a result of growth in volume licensing agreement revenue and strong transactional license sales to businesses. The increase in business revenue also included a 21% increase in Microsoft Dynamics customer billings. Consumer revenue decreased $80 million or 2%, reflecting the consumer launch of the 2007 Microsoft Office system in the prior fiscal year.
MBD operating income increased reflecting growth in revenue, partially offset by increased sales and marketing expenses, research and development expenses, and cost of revenue. Sales and marketing expenses increased $462 million or 13%, reflecting increased expenses associated with our corporate sales force. Research and development expenses increased $228 million or 18%, primarily driven by an increase in headcount-related expenses and a $35 million in-process research and development expense related to the acquisition of FAST. Cost of revenue increased $225 million or 29%, primarily driven by an increase in online services infrastructure costs and product costs related to retail packaged product sales. Headcount-related expenses increased 10%, driven by an increase in headcount during the year.
Fiscal year 2007 compared with fiscal year 2006
MBD revenue increased primarily reflecting licensing of the 2007 Microsoft Office system and included a favorable impact from foreign currency exchange rates of $247 million or two percentage points. Revenue from consumer sales increased $339 million or 10% while revenue from business sales increased $1.6 billion or 15%. The increase in business revenue included a 21% increase in Microsoft Dynamics customer billings.
MBD operating income increased reflecting the increased revenue, partially offset by increased sales and marketing expenses and cost of revenue primarily associated with the 2007 Microsoft Office system. The increase in sales and marketing expenses reflected increased headcount-related expenses, increased sales support costs from our Enterprise Software Advisor channel partners, and increased launch-related marketing expenses. Headcount-related expenses increased 8%, driven by an increase in headcount during the year.
Fiscal Year 2009 Outlook
We expect revenue to continue to increase over the prior year due to the strong performance of the 2007 Microsoft Office system and business demand for other applications. Fiscal year 2009 represents an important year in delivering on our software plus services strategy with the upcoming releases of Exchange Online, SharePoint Online, and Office Communication Server Online.
Entertainment and Devices Division
| (In millions, except percentages) | 2008 | 2007 | 2006 | Percentage Change 2008 versus 2007 |
Percentage Change 2007 versus 2006 |
|---|---|---|---|---|---|
| Revenue | $8,140 | $ 6,069 | $ 4,732 | 34% | 28% |
| Operating income (loss) | $ 426 | $(1,969) | $(1,339) | * | (47)% |
* Not meaningful
Entertainment and Devices Division (EDD) offerings include the Xbox 360 platform (which includes the Microsoft Xbox video game console system, Xbox 360 video games, Xbox Live, and Xbox 360 accessories), the Zune digital music and entertainment platform, PC software games, online games and services, Mediaroom (our Internet protocol television software), the Surface computing platform, mobile and embedded device platforms, and other devices. EDD leads the development efforts for our line of consumer software and hardware products including application software for Macintosh computers and Microsoft PC hardware products, and is responsible for all retail sales and marketing for Microsoft Office and the Windows operating systems. In April 2008, we acquired Danger, Inc. (Danger), a software-as-a-service company that provides mobile operators with an integrated end-to-end solution to deliver mobile data and Internet services to their subscribers.
Fiscal year 2008 compared with fiscal year 2007
EDD revenue increased primarily due to increased Xbox 360 platform sales. Xbox 360 platform and PC game revenue increased $1.7 billion or 41% as a result of increased Xbox 360 console sales, video game sales led by Halo 3, Xbox Live revenue, and Xbox 360 accessory sales. We shipped 8.7 million Xbox 360 consoles during fiscal year 2008, compared with 6.6 million Xbox 360 consoles during fiscal year 2007.
EDD operating income increased primarily due to increased revenue and decreased cost of revenue, partially offset by increased research and development expenses and sales and marketing expenses. Cost of revenue decreased $683 million or 13%, reflecting the impact of the $1.1 billion Xbox 360 charge in fiscal year 2007 (which primarily related to the warranty expansion), partially offset by increased Xbox 360 product costs related to increased unit console sales. Research and development expenses increased $242 million or 18%, primarily reflecting increased headcount-related expenses and costs related to the acquisition of Danger, including a $24 million in-process research and development expense. Sales and marketing expenses increased $93 million or 8%, primarily reflecting increased headcount-related expenses and increased bad debt expense. Headcount-related expenses increased 21%, driven by an increase in headcount during the year.
Fiscal year 2007 compared with fiscal year 2006
EDD revenue increased primarily due to increased Xbox 360 platform and Zune sales. We shipped 6.6 million Xbox 360 consoles during fiscal year 2007 as compared to 5.0 million consoles during fiscal year 2006. Xbox and PC game revenue increased $650 million or 19% as a result of increased Xbox 360 platform sales, partially offset by decreased sales of the first generation Xbox console and related accessories and video games. Zune, consumer hardware and software, and Mediaroom revenue increased $539 million or 65% primarily driven by the Zune launch in November 2006.
EDD operating loss increased primarily due to the $1.1 billion Xbox 360 charge recognized in the fourth quarter of fiscal year 2007 and Zune launch-related expenses. The increase in operating loss was partially offset by increased Xbox 360 platform sales and decreased Xbox 360 console manufacturing costs. Headcount-related expenses increased 14%, driven by an increase in headcount during the year.
Fiscal Year 2009 Outlook
We expect revenue to be flat or to decrease due to year-over-year variations in product launches, volume, mix, and prices across our portfolio of products and services. We expect sustained profitability for fiscal year 2009.
Corporate-Level Activity
| (In millions, except percentages) | 2008 | 2007 | 2006 | Percentage Change 2008 versus 2007 |
Percentage Change 2007 versus 2006 |
|---|---|---|---|---|---|
| Corporate-level activity | $(6,704) | $(4,777) | $(4,804) | (40)% | 1% |
Certain corporate-level activity, including expenses related to corporate operations associated with broad-based sales and marketing, product support services, human resources, legal, finance, information technology, corporate development and procurement activities, research and development and other costs, and legal settlements and contingencies, is not allocated to our segments.
Fiscal year 2008 compared with fiscal year 2007
Corporate-level expenses increased during fiscal year 2008, reflecting increased costs for legal settlements and legal contingencies and a 12% increase in headcount-related expenses. We incurred $1.8 billion of legal charges during the year primarily related to the European Commission fine of $1.4 billion (€899 million) as compared with $511 million of legal charges during the prior year. The increase in headcount-related expenses reflects an increase in headcount during the year.
Fiscal year 2007 compared with fiscal year 2006
Corporate-level expenses increased primarily driven by increased headcount-related expenses offset by decreased costs for legal settlements and legal contingencies. Headcount-related expenses increased 25%, driven by an increase in headcount and an increase in salaries and benefits for existing headcount. We incurred $511 million in legal charges during fiscal year 2007, primarily related to antitrust and unfair competition consumer class actions, intellectual property claims, and an extension payment to Sun Microsystems, Inc. under our Limited Patent Covenant and Standstill Agreement. We incurred $1.3 billion in legal charges during fiscal year 2006 which included settlement expense of $361 million related to our settlement with RealNetworks, Inc. as well as other intellectual property and antitrust matters, a $351 million (€281 million) fine imposed by the European Commission in July 2006 related to its 2004 decision in its competition law investigation of Microsoft, and an extension payment to Sun Microsystems, Inc.
Operating Expenses
Cost of Revenue
| (In millions, except percentages) | 2008 | 2007 | 2006 | Percentage Change 2008 versus 2007 |
Percentage Change 2007 versus 2006 |
|---|---|---|---|---|---|
| Cost of revenue | $11,598 | $10,693 | $ 7,650 | 8% | 40% |
| As a percent of revenue | 19% | 21% | 17% | (2)ppt | 4ppt |
Cost of revenue includes manufacturing and distribution costs for products sold and programs licensed, operating costs related to product support service centers and product distribution centers, costs incurred to support and maintain Internet-based products and services, warranty costs, inventory valuation adjustments, costs associated with the delivery of consulting services, and the amortization of capitalized research and development costs associated with software products that have reached technological feasibility. Cost of revenue increased in fiscal year 2008, reflecting increased data center and equipment costs, online content expenses, and increased costs associated with the growth in our consulting services, partially offset by decreased Xbox 360 costs. Xbox 360 costs decreased because of the $1.1 billion charge in fiscal year 2007 (which primarily related to the expansion of our Xbox 360 warranty coverage), partially offset by increased Xbox 360 product costs, reflecting growth in unit console sales. Cost of revenue increased in fiscal year 2007, primarily driven by the Xbox 360 warranty charge, increased Windows Vista product costs, increased OSB data center costs, and costs associated with the growth in consulting services.
Research and Development
| (In millions, except percentages) | 2008 | 2007 | 2006 | Percentage Change 2008 versus 2007 |
Percentage Change 2007 versus 2006 |
|---|---|---|---|---|---|
| Research and development | $8,164 | $7,121 | $6,584 | 15% | 8% |
| As a percent of revenue | 14% | 14% | 15% | – ppt | (1)ppt |
Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, the amortization of purchased software code and services content, and in-process research and development. Research and development expenses increased during fiscal year 2008 reflecting increased headcount-related expenses, increased product development costs, and in-process research and development expenses related to acquisitions during the year. Headcount-related expenses increased 12% during fiscal year 2008, reflecting an increase in headcount during the year. Research and development costs increased during fiscal year 2007, primarily due to increased headcount-related expenses which grew 8%, reflecting growth in headcount during the year.
Sales and Marketing
| (In millions, except percentages) | 2008 | 2007 | 2006 | Percentage Change 2008 versus 2007 |
Percentage Change 2007 versus 2006 |
|---|---|---|---|---|---|
| Sales and marketing | $13,039 | $11,455 | $9,818 | 14% | 17% |
| As a percent of revenue | 22% | 22% | 22% | – ppt | – ppt |
Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel and advertising, promotions, trade shows, seminars, and other programs. Sales and marketing expenses increased during fiscal year 2008, primarily reflecting increased headcount-related expenses and increased corporate marketing and advertising campaigns. Headcount-related expenses increased 14% during fiscal year 2008, reflecting an increase in headcount during the year. Sales and marketing expenses increased during fiscal year 2007 primarily because of increased headcount-related expenses and increased marketing costs related to product launches. Headcount-related expenses increased 22% during fiscal year 2007, driven by an increase in headcount during the year.
General and Administrative
| (In millions, except percentages) | 2008 | 2007 | 2006 | Percentage Change 2008 versus 2007 |
Percentage Change 2007 versus 2006 |
|---|---|---|---|---|---|
| General and administrative | $5,127 | $ 3,329 | $ 3,758 | 54% | (11)% |
| As a percent of revenue | 8% | 7% | 8% | 1ppt | (1)ppt |
General and administrative costs include payroll, employee benefits, stock-based compensation expense and other headcount-related expenses associated with finance, legal, facilities, certain human resources, other administrative headcount, and legal and other administrative fees. General and administrative expenses increased during fiscal year 2008, reflecting increased costs for legal settlements and legal contingencies, increased consulting and professional fees, and increased headcount-related expenses. We incurred $1.8 billion of legal charges during fiscal year 2008, primarily related to the European Commission fine of $1.4 billion (€899 million) as compared with $511 million of legal charges during fiscal year 2007. Headcount-related expenses increased 7% during fiscal year 2008, reflecting an increase in headcount during the year. During fiscal year 2007, we incurred $511 million of legal charges primarily related to antitrust and unfair competition consumer class actions, intellectual property claims, and extension payment to Sun Microsystems, Inc. as compared with $1.3 billion of legal charges in fiscal year 2006. Headcount-related expenses increased 15% during fiscal year 2007, driven by an increase in headcount during the year.
Investment Income and Other
The components of investment income and other were as follows:
| (In millions, except percentages) | 2008 | 2007 | 2006 | Percentage Change 2008 versus 2007 |
Percentage Change 2007 versus 2006 |
|---|---|---|---|---|---|
| Dividends and interest | $ 888 | $1,319 | $1,510 | (33)% | (13)% |
| Net recognized gains on investments | 346 | 650 | 161 | (47)% | 304% |
| Net gains (losses) on derivatives | 226 | (358) | (99) | * | 262% |
| Other | (138) | (34) | 218 | 306% | * |
| Investment income and other | $1,322 | $1,577 | $1,790 | (16)% | (12)% |
* Not meaningful
Fiscal year 2008 compared with fiscal year 2007
Dividends and interest income decreased reflecting lower interest rates on our fixed-income investments and a reduction in the average balance of interest-bearing investments owned. Net recognized gains on investments, which include other-than-temporary impairments of $312 million during fiscal year 2008 and $25 million during fiscal year 2007, decreased primarily due to declines in equity values as a result of the recent stock market decline. Net gains on derivatives increased primarily due to higher net gains on equity, commodity, and interest rate derivatives. Other of $138 million includes the correction of several immaterial items from prior periods.
Fiscal year 2007 compared with fiscal year 2006
Dividends and interest income declined reflecting a decline in the average balance of dividend and interest-bearing investments owned, partly offset by higher interest rates received on our fixed-income investments. Net recognized gains on investments, which include other-than-temporary impairments of $25 million during fiscal year 2007 and $408 million in fiscal year 2006, increased primarily due to lower other-than-temporary impairments and gains on sales of fixed-income investments as compared to losses in fiscal year 2006, partly offset by fewer gains on the sale of equity investments. Derivative losses were primarily driven by net losses in time value on foreign currency contracts used to hedge anticipated foreign currency revenues. Other in fiscal year 2006 includes $195 million of gains that resulted from the restructuring of joint venture relationships between Microsoft and NBC related to MSNBC Cable L.L.C. and MSNBC Interactive News, L.L.C.
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, among other factors, we evaluate general market conditions, the duration and extent to which the fair value is less than cost, and 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 lend certain fixed-income and equity securities to increase investment returns. The loaned securities continue to be carried as investments on our balance sheet. Collateral and/or security interest is determined based upon the underlying security and the creditworthiness of the borrower. Cash collateral is recorded as an asset with a corresponding liability.
We use derivative instruments to manage exposures to interest rates, equity prices, and foreign currency markets and to facilitate portfolio diversification. Gains and losses arising from derivatives not designated as accounting hedges are in large part economically offset by unrealized losses and gains, respectively, in the underlying securities which are recorded as a component of other comprehensive income.
Income Taxes
Our effective tax rates for fiscal years 2008, 2007, and 2006 were 26%, 30%, and 31%, respectively. Our effective tax rates are less than the statutory tax rate due to foreign earnings taxed at lower rates. The decreased rate in fiscal year 2008 resulted from resolution of tax positions related to our settlement with the Internal Revenue Service (IRS) for its 2000-2003 examination. This decline was partially offset by the tax effect of the European Commission fine of $1.4 billion (€899 million), which was not tax deductible. The fiscal year 2007 rate reflects a recurring effective tax rate of 31%, offset by a $195 million reduction resulting from various changes in tax positions taken in prior periods, related primarily to favorable developments in an IRS position and multiple foreign audit assessments. During fiscal year 2006, we recorded a tax benefit of $108 million from the resolution of state audits and recorded a charge of $351 million (€281 million) from the European Commission fine which was not tax deductible.
On July 1, 2007, we adopted the provisions of the Financial Accounting Standards Board (FASB) Interpretation No. 48 (FIN 48) Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109, which provides a financial statement recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. Adopting FIN 48 had the following impact on our financial statements: increased current assets by $228 million, long-term assets by $1.1 billion, long-term liabilities by $2.1 billion, and our retained deficit by $395 million; and decreased our income taxes payable by $394 million. As of June 30, 2008, we had $3.2 billion of unrecognized tax benefits of which $2.3 billion, if recognized, would affect our effective tax rate. As of July 1, 2007, we had $7.1 billion of unrecognized tax benefits of which $5.3 billion, if recognized, would affect our effective tax rate. Our policy is to include interest and penalties related to unrecognized tax benefits in income tax expense. Interest totaled $121 million in fiscal year 2008. As of June 30, 2008 and July 1, 2007, we had accrued interest related to uncertain tax positions of $324 million and $863 million, respectively, net of federal income tax benefits, on our balance sheets.
Financial Condition
Cash, cash equivalents, and short-term investments totaled $23.7 billion and $23.4 billion as of June 30, 2008 and 2007, respectively. Equity and other investments were $6.6 billion and $10.1 billion as of June 30, 2008 and 2007, respectively. Our investments consist primarily of fixed-income securities, diversified among industries and individual issuers. Our investments are generally liquid and investment grade. The portfolio is invested predominantly in U.S.-dollar-denominated securities, but also includes foreign-denominated securities in order to diversify financial risk. As a result of the special dividend paid in the second quarter of fiscal year 2005 and shares repurchased, our retained deficit, including accumulated other comprehensive income, was $26.6 billion at June 30, 2008. Our retained deficit is not expected to impact our future ability to operate or pay dividends given our continuing profitability and strong cash and financial position.
In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to price positions. This pricing methodology applies to exchange-traded mutual funds, domestic and international equities, U.S. treasuries, and agency securities. If quoted prices in active markets for identical assets or liabilities are not available to price positions, then we use inputs other than the quoted prices that are observable either directly or indirectly. Assets and liabilities measured using unobservable inputs are an immaterial portion of our portfolio.
While we own certain mortgage- and asset-backed fixed-income securities, our portfolio as of June 30, 2008 does not contain direct exposure to subprime mortgages or structured vehicles that derive their value from subprime collateral. The majority of the mortgage-backed securities are collateralized by prime residential mortgages and carry a 100% principal and interest guarantee, primarily from Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and Government National Mortgage Association. The remainder of the mortgage position is collateralized by high quality international prime residential mortgage loans.
Unearned Revenue
Unearned revenue is comprised of the following items:
Volume licensing programs – Represents customer billings for multi-year licensing arrangements, paid either upfront or annually at the beginning of each billing coverage period, which are accounted for as subscriptions with revenue recognized ratably over the billing coverage period.
Undelivered elements – Represents free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis. This revenue deferral is applicable for Windows XP and prior versions shipped as retail packaged products, products licensed to original equipment manufacturers (OEM), and perpetual licenses for current products under our Open and Select volume licensing programs. The amount recorded as unearned is based on the sales price of those elements when sold separately and is recognized ratably on a straight-line basis over the related product’s life cycle. The percentage of revenue recorded as unearned due to undelivered elements ranges from approximately 15% to 25% of the sales price for Windows XP Home and approximately 5% to 15% of the sales price for Windows XP Professional, depending on the terms and conditions of the license and prices of the elements. Product life cycles are currently estimated at three and one-half years for Windows operating systems.
Other – Represents payments for post-delivery support and consulting services to be performed in the future, online advertising for which the advertisement has yet to be displayed, Microsoft Dynamics business solutions products, Xbox Live subscriptions, Mediaroom, and other offerings for which we have been paid upfront and earn the revenue when we provide the service or software, or otherwise meet the revenue recognition criteria.
The following table outlines the expected recognition of unearned revenue as of June 30, 2008:
| (In millions) | Recognition of Unearned Revenue |
|---|---|
| Three months ended: | |
| September 30, 2008 | $ 5,120 |
| December 31, 2008 | 4,033 |
| March 31, 2009 | 2,775 |
| June 30, 2009 | 1,469 |
| Thereafter | 1,900 |
| Unearned revenue | $15,297 |
Cash Flows
Fiscal year 2008 compared with fiscal year 2007
Cash flow from operations increased $3.8 billion due to an increase in cash received from customers driven by 18% revenue growth, partially offset by the $1.4 billion (€899 million) payment of the European Commission fine. Cash used for financing decreased $11.6 billion primarily due to a $15.0 billion decrease in common stock repurchases, partially offset by a $3.3 billion decrease in cash proceeds from the issuance of common stock. Cash used for investing was $4.6 billion for fiscal year 2008 as compared with cash provided of $6.1 billion for fiscal year 2007. This decrease was primarily due to a $6.9 billion increase in cash paid for acquisition of companies, reflecting the purchase of aQuantive in the first quarter of fiscal year 2008, a $918 million increase in purchases of property and equipment, and a $3.1 billion decrease in cash from combined investment purchases, sales, and maturities.
As a result of our settlement related to the 2000-2003 examination, we paid the IRS approximately $3.1 billion during the first quarter of fiscal year 2009.
Fiscal year 2007 compared with fiscal year 2006
Cash flow from operations increased $3.4 billion due to an increase in cash received from customers driven by 15% revenue growth, along with a $1.6 billion decrease in cash outflow for other current assets primarily reflecting changes in inventory. Cash used for financing increased $4.0 billion. Several events occurred during fiscal year 2007 affecting cash used for financing. We issued $6.8 billion of common stock, including $3.3 billion related to 113 million call options exercised by JPMorgan in December 2006. We also completed our tender offer on August 17, 2006, which was included in the $27.6 billion of common stock repurchases. Cash from investing decreased $1.9 billion due to a $3.5 billion decline in securities lending activity where cash collateral is received from the counterparty along with $1.2 billion spent on acquisitions of companies and additions to property and equipment. These impacts were partially offset by a $2.8 billion increase in net cash from combined investment purchases, sales, and maturities.
We have no material long-term debt. Stockholders’ equity at June 30, 2008, was $36.3 billion. We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology. Additions to property and equipment will continue, including new facilities, data centers, and computer systems for research and development, sales and marketing, support, and administrative staff. Commitments for constructing new buildings were $1.2 billion on June 30, 2008. We have operating leases for most U.S. and international sales and support offices and certain equipment under which we incurred rental expense totaling $398 million, $325 million, and $271 million in fiscal years 2008, 2007, and 2006, respectively. 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.
During fiscal years 2008 and 2007, our Board of Directors declared the following dividends:
| Declaration Date | Per Share Dividend | Record Date | Total Amount | Payment Date |
|---|---|---|---|---|
| (in millions) | ||||
| (Fiscal year 2008) | ||||
| September 12, 2007 | $0.11 | November 15, 2007 | $1,034 | December 13, 2007 |
| December 19, 2007 | $0.11 | February 21, 2008 | $021,3 | March 13, 2008 |
| March 17, 2008 | $0.11 | May 15, 2008 | $1,020 | June 12, 2008 |
| June 11, 2008 | $0.11 | August 21, 2008 | $1,007 | September 11, 2008 |
| (Fiscal year 2007) | ||||
| September 13, 2006 | $0.10 | November 16, 2006 | $980 | December 14, 2006 |
| December 20, 2006 | $0.10 | February 15, 2007 | $978 | March 8, 2007 |
| March 26, 2007 | $0.10 | May 17, 2007 | $952 | June 14, 2007 |
| June 27, 2007 | $0.10 | August 16, 2007 | $938 | September 13, 2007 |
On July 20, 2006, we announced the completion of the repurchase program initially approved by our Board of Directors on July 20, 2004 to buy back up to $30.0 billion in Microsoft common stock. During fiscal year 2006, we repurchased 754 million shares, or $19.8 billion, of our common stock under this plan. On July 20, 2006, we announced that our Board of Directors authorized two new share repurchase programs: a $20.0 billion tender offer, which was completed on August 17, 2006; and authorization for up to an additional $20.0 billion ongoing share repurchase program with an expiration of June 30, 2011. Under the tender offer, we repurchased approximately 155 million shares of common stock, or 1.5% of our common shares outstanding, for approximately $3.8 billion at a price per share of $24.75. On August 18, 2006, we announced that the authorization for the $20.0 billion ongoing share repurchase program had been increased by approximately $16.2 billion. As a result, we were authorized to repurchase additional shares in an amount up to $36.2 billion through June 30, 2011. As of June 30, 2008, approximately $2.7 billion remained of the $36.2 billion approved repurchase amount.
We believe existing cash, cash equivalents, and short-term investments, together with funds generated from operations, should be sufficient to meet operating requirements, regular quarterly dividends, and planned share repurchases. Our philosophy regarding the maintenance of a balance sheet with a large component of cash and short-term investments, as well as equity and other investments, reflects our views on potential future capital requirements related to research and development, creation and expansion of sales distribution channels, investments and acquisitions, share dilution management, legal risks, and challenges to our business model. We regularly assess our investment management approach in view of our current and potential future needs.
Off-Balance Sheet Arrangements and Contractual Obligations
We provide indemnifications of varying scope and amount to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products. We evaluate estimated losses for these indemnifications under SFAS No. 5, Accounting for Contingencies, as interpreted by FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. We consider factors such as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered material costs as a result of these obligations and have not accrued any material liabilities related to these indemnifications in our financial statements.
Contractual Obligations
The following table summarizes our outstanding contractual obligations as of June 30, 2008:
| (In millions) | |||||
|---|---|---|---|---|---|
| Payments due by period | |||||
| Fiscal Years | 2009 | 2010-2012 | 2013-2015 | 2016 and thereafter |
Total |
| Long-term debt | $ – | $ – | $ – | $ – | $ – |
| Construction commitments(1)(2) | 1,226 | – | – | – | 1,226 |
| Lease obligations: | |||||
| Capital leases | – | 1 | – | – | 1 |
| Operating leases(3) | 440 | 831 | 522 | 415 | 2,208 |
| Purchase commitments(2) | 2,520 | 5 | – | – | 2,525 |
| Other long-term liabilities(4) | 196 | 105 | – | – | 301 |
| Total contractual obligations(5) | $4,382 | $942 | $522 | $415 | $6,261 |
- We have certain commitments for the construction of buildings. We expect to fund these commitments with existing cash and cash flows from operations.
- The amounts presented as purchase and construction commitments include all known open purchase orders and all known contracts that are take-or-pay contracts. We expect to fund these commitments with existing cash and cash flows from operations.
- Our future minimum rental commitments under noncancellable leases comprise the majority of the operating lease obligations presented above. We expect to fund these commitments with existing cash and cash flows from operations.
- We have excluded long-term tax contingencies and other tax liabilities of $3.8 billion and other long-term contingent liabilities of approximately $500 million (related to the antitrust and unfair competition class action lawsuits) from the amounts presented as the amounts that will be settled in cash are not known. We have also excluded non-cash items of $77 million and unearned revenue of $1.9 billion.
- We have excluded $3.1 billion of current taxes payable from the amounts presented. This amount was paid to the IRS during the first quarter of fiscal year 2009 as a result of our settlement related to the 2000-2003 examination.
RECENTLY ISSUED ACCOUNTING STANDARDS
Recently Adopted Accounting Pronouncements
On July 1, 2007, we adopted FIN 48 which provides a financial statement recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. Under FIN 48, we may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. FIN 48 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. Upon adoption, we recognized a $395 million charge to our beginning retained deficit as a cumulative effect of a change in accounting principle. See Note 11—Income Taxes of the Notes to Financial Statements.
On July 1, 2007, we adopted Emerging Issues Task Force Issue No. 06-2 (EITF 06-2), Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43. EITF 06-2 requires companies to accrue the costs of compensated absences under a sabbatical or similar benefit arrangement over the requisite service period. Upon adoption, we recognized a $17 million charge to our beginning retained deficit as a cumulative effect of a change in accounting principle.
Recent Accounting Pronouncements Not Yet Adopted
In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133, which requires additional disclosures about the objectives of the derivative instruments and hedging activities, the method of accounting for such instruments under SFAS No. 133 and its related interpretations, and a tabular disclosure of the effects of such instruments and related hedged items on our financial position, financial performance, and cash flows. SFAS No. 161 is effective for us beginning January 1, 2009. We are currently assessing the potential impact that adoption of SFAS No. 161 may have on our financial statements.
In December 2007, the FASB issued SFAS No. 141R, Business Combinations, which replaces SFAS No. 141. The statement retains the purchase method of accounting for acquisitions, but requires a number of changes, including changes in the way assets and liabilities are recognized in the purchase accounting. It also changes the recognition of assets acquired and liabilities assumed arising from contingencies, requires the capitalization of in-process research and development at fair value, and requires the expensing of acquisition-related costs as incurred. SFAS No. 141R is effective for us beginning July 1, 2009 and will apply prospectively to business combinations completed on or after that date.
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51, which changes the accounting and reporting for minority interests. Minority interests will be recharacterized as noncontrolling interests and will be reported as a component of equity separate from the parent’s equity, and purchases or sales of equity interests that do not result in a change in control will be accounted for as equity transactions. In addition, net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the income statement and, upon a loss of control, the interest sold, as well as any interest retained, will be recorded at fair value with any gain or loss recognized in earnings. SFAS No. 160 is effective for us beginning July 1, 2009 and will apply prospectively, except for the presentation and disclosure requirements, which will apply retrospectively. We are currently assessing the potential impact that adoption of SFAS No. 160 may have on our financial statements.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 gives us the irrevocable option to carry many financial assets and liabilities at fair values, with changes in fair value recognized in earnings. SFAS No. 159 is effective for us beginning July 1, 2008. We do not believe SFAS No. 159 will have a material impact on our financial statements.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This statement does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. In February 2008, the FASB issued FASB Staff Position (FSP) 157-2, Effective Date of FASB Statement No. 157, which delays the effective date of SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). SFAS No. 157 is effective for us beginning July 1, 2008; FSP 157-2 delays the effective date for certain items to July 1, 2009. We do not believe SFAS No. 157 will have a material impact on our financial statements.
APPLICATION OF CRITICAL ACCOUNTING POLICIES
Our financial statements and accompanying notes are prepared in accordance with U.S. GAAP. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies for us include revenue recognition, impairment of investment securities, impairment of goodwill, accounting for research and development costs, accounting for contingencies, accounting for income taxes, accounting for stock-based compensation, and accounting for product warranties.
We account for the licensing of software in accordance with American Institute of Certified Public Accountants Statement of Position (SOP) 97-2, Software Revenue Recognition. The application of SOP 97-2 requires judgment, including whether a software arrangement includes multiple elements, and if so, whether vendor-specific objective evidence (VSOE) of fair value exists for those elements. For some of our products, customers receive certain elements of our products over a period of time. These elements include 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 fair value of these elements is recognized over the estimated life cycle for the Windows XP and previous PC operating systems. For Windows Vista, there are no significant undelivered elements and accordingly, no license revenue is deferred for Windows Vista sales. Changes to the elements in a software arrangement, the ability to identify VSOE for those elements, the fair value of the respective elements, and changes to a product’s estimated life cycle could materially impact the amount of earned and unearned revenue. Judgment is also required to assess whether future releases of certain software represent new products or upgrades and enhancements to existing products.
SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and Staff Accounting Bulletin Topic 5M, Accounting for Noncurrent Marketable Equity Securities, provide guidance on determining when an investment is other-than-temporarily impaired. Investments are reviewed quarterly for indicators of other-than-temporary impairment. This determination requires significant judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, and 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. If market, industry, and/or investee conditions deteriorate, we may incur future impairments.
SFAS No. 142, Goodwill and Other Intangible Assets, requires that goodwill be tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (July 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition or sale or disposition of a significant portion of a reporting unit. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated using a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, the useful life over which cash flows will occur, and determination of our weighted average cost of capital. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit. We allocate goodwill to reporting units based on the reporting unit expected to benefit from the combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach.
We account for research and development costs in accordance with applicable accounting pronouncements, including SFAS No. 2, Accounting for Research and Development Costs, and SFAS No. 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed. SFAS No. 86 specifies that costs incurred internally in researching and developing a computer software product should be charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, all software costs should be 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 outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. SFAS No. 5, Accounting for Contingencies, requires that an estimated loss from a loss contingency such as a legal proceeding or claim should be 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 results of operations, financial position, or our cash flows.
SFAS No. 109, Accounting for Income Taxes, establishes financial accounting and reporting standards for the effect of 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. Accruals for uncertain tax positions are provided for in accordance with the requirements of FIN 48. Under FIN 48, we may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. FIN 48 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 position, results of operations, or cash flows.
We account for stock-based compensation in accordance with SFAS No. 123(R), Share-Based Payment. Under the fair value recognition provisions of this statement, share-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service period. Determining the fair value of share-based awards at the grant date requires judgment, including estimating expected dividends. In addition, judgment is also required in estimating the amount of share-based awards that are expected to be forfeited. If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations could be materially impacted.
We account for product warranties in accordance with SFAS No. 5, Accounting for Contingencies. We provide for the estimated costs of hardware and software warranties at the time the related revenue is recognized. For hardware warranty, we estimate the costs based on historical and projected product failure rates, historical and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and country in which we do business, but generally include parts and labor over a period generally ranging from 90 days to three years. For software warranty, we estimate the costs to provide bug fixes, such as security patches, over the life of the software. We regularly reevaluate our estimates to assess the adequacy of the recorded warranty liabilities and adjust the amounts as necessary.
Statement of Management’s Responsibility for Financial Statements
Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. The consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America.
The Company designs and maintains accounting and internal control systems to provide reasonable assurance at reasonable cost that assets are safeguarded against loss from unauthorized use or disposition, and that the financial records are reliable for preparing financial statements and maintaining accountability for assets. These systems are augmented by written policies, an organizational structure providing division of responsibilities, careful selection and training of qualified personnel, and a program of internal audits.
The Company engaged Deloitte & Touche LLP, an independent registered public accounting firm, to audit and render an opinion on the consolidated financial statements and internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States).
The Board of Directors, through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, internal auditors, and our independent registered public accounting firm to ensure that each is meeting its responsibilities and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal auditors each have full and free access to the Audit Committee.
Steven A. Ballmer
Chief Executive Officer
Christopher P. Liddell
Senior Vice President, Finance and Administration; Chief Financial Officer
Frank H. Brod
Corporate Vice President, Finance and Administration; Chief Accounting Officer