-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, TvFjrShn9/56XttwKGV1itvDLcWA9UNVnDAQuLnCVGedzmGQKMTnxeA7t5CuF94N mXIvecUaphdEfZW72Kp/qg== 0001193125-08-215214.txt : 20081023 0001193125-08-215214.hdr.sgml : 20081023 20081023161626 ACCESSION NUMBER: 0001193125-08-215214 CONFORMED SUBMISSION TYPE: 8-K PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 20081023 ITEM INFORMATION: Other Events ITEM INFORMATION: Financial Statements and Exhibits FILED AS OF DATE: 20081023 DATE AS OF CHANGE: 20081023 FILER: COMPANY DATA: COMPANY CONFORMED NAME: MICROSOFT CORP CENTRAL INDEX KEY: 0000789019 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-PREPACKAGED SOFTWARE [7372] IRS NUMBER: 911144442 STATE OF INCORPORATION: WA FISCAL YEAR END: 0630 FILING VALUES: FORM TYPE: 8-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-14278 FILM NUMBER: 081137514 BUSINESS ADDRESS: STREET 1: ONE MICROSOFT WAY CITY: REDMOND STATE: WA ZIP: 98052-6399 BUSINESS PHONE: 425-882-8080 MAIL ADDRESS: STREET 1: ONE MICROSOFT WAY CITY: REDMOND STATE: WA ZIP: 98052-6399 8-K 1 d8k.htm FORM 8-K Form 8-K

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

 

FORM 8-K

 

 

CURRENT REPORT PURSUANT

TO SECTION 13 OR 15(D) OF THE

SECURITIES EXCHANGE ACT OF 1934

Date of report (Date of earliest event reported) October 23, 2008

 

 

Microsoft Corporation

(Exact Name of Registrant as Specified in Its Charter)

 

 

Washington

(State or Other Jurisdiction of Incorporation)

 

0-14278   91-1144442
(Commission File Number)   (IRS Employer Identification No.)
One Microsoft Way, Redmond, Washington   98052-6399
(Address of Principal Executive Offices)   (Zip Code)

(425) 882-8080

(Registrant’s Telephone Number, Including Area Code)

 

 

 

(Former Name or Former Address, if Changed Since Last Report)

 

 

Check the appropriate box below if the Form 8-K filing is intended to simultaneously satisfy the filing obligation of the registrant under any of the following provisions (see General Instruction A.2. below):

 

¨ Written communications pursuant to Rule 425 under the Securities Act (17 CFR 230.425)

 

¨ Soliciting material pursuant to Rule 14a-12 under the Exchange Act (17 CFR 240.14a-12)

 

¨ Pre-commencement communications pursuant to Rule 14d-2(b) under the Exchange Act (17 CFR 240.14d-2(b))

 

¨ Pre-commencement communications pursuant to Rule 13e-4(c) under the Exchange Act (17 CFR 240.13e-4(c))

 

 

 

Item 8.01 Other Events

Attached as Exhibit 100 to this report are the following materials from Microsoft Corporation’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2008, filed on October 23, 2008, formatted in XBRL (Extensible Business Reporting Language): (i) the information contained in Item 1 (a)-(e) and Items 2-4 of Part I – Financial Information, and (ii) the information contained in Items 1, 1A, and 2 of Part II – Other Information. Users of this data are advised pursuant to Rule 401 of Regulation S-T that the financial information contained in the XBRL documents is unaudited and these are not the official publicly filed financial statements of Microsoft Corporation. The purpose of submitting these XBRL formatted documents is to test the related format and technology and, as a result, investors should continue to rely on the official filed version of the furnished documents and not rely on this information in making investment decisions.

In accordance with Rule 402 of Regulation S-T, the information in this Current Report on Form 8-K, including Exhibit 100, shall not be deemed to be “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), or otherwise subject to the liability of that section, and shall not be incorporated by reference into any registration statement or other document filed under the Securities Act of 1933, as amended, or the Exchange Act, except as shall be expressly set forth by specific reference in such filing.

 

Item 9.01 Financial Statements and Exhibits

(d) Exhibits

 

100    The following materials from Microsoft Corporation’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2008, filed on October 23, 2008, formatted in XBRL (Extensible Business Reporting Language): (i) the information contained in Item 1 (a)-(e) and Items 2-4 of Part I – Financial Information, and (ii) the information contained in Items 1, 1A, and 2 of Part II – Other Information.

 

2

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.

 

    MICROSOFT CORPORATION
    (Registrant)
Date: October 23, 2008     /s/ FRANK H. BROD
   

Frank H. Brod

Corporate Vice President, Finance & Administration;

Chief Accounting Officer

 

3

INDEX TO EXHIBITS

 

Exhibit No.

   

Description

100    The following materials from Microsoft Corporation’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2008, filed on October 23, 2008, formatted in XBRL (Extensible Business Reporting Language): (i) the information contained in Item 1 (a)-(e) and Items 2-4 of Part I – Financial Information, and (ii) the information contained in Items 1, 1A, and 2 of Part II – Other Information.

 

4

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xbrli:shares xbrli:shares iso4217:USD xbrli:pure xbrli:pure 8895572720 The aggregate market value of the registrant's common stock held by non-affiliates of the registrant based on the closing sale price as reported on the NASDAQ National Market System. 0 15061000000 13762000000 2848000000 2675000000 2283000000 1837000000 3044000000 2683000000 887000000 718000000 9062000000 7913000000 5999000000 5849000000 -8000000 367000000 5991000000 6216000000 1618000000 1927000000 4373000000 4289000000 0.48 0.46 0.48 0.45 9084000000 9380000000 9183000000 9513000000 0.13 0.11 9004000000 10339000000 11718000000 13323000000 1011000000 2491000000 20722000000 23662000000 9535000000 13589000000 168000000 153000000 1640000000 985000000 1974000000 2017000000 3331000000 2989000000 37202000000 43242000000 6552000000 6242000000 6622000000 6302000000 4381000000 6588000000 12291000000 12108000000 1899000000 1973000000 1041000000 949000000 1751000000 1691000000 65117000000 72793000000 3351000000 4034000000 2138000000 2934000000 514000000 3248000000 11815000000 13397000000 1070000000 2614000000 1975000000 0 3520000000 3659000000 24383000000 29886000000 1662000000 1900000000 5478000000 4721000000 24000000000 8977000000 24000000000 9151000000 61655000000 62849000000 877000000 1140000000 -28061000000 -26563000000 33594000000 36286000000 65117000000 72793000000 585000000 435000000 443000000 333000000 -36000000 187000000 44000000 69000000 376000000 357000000 4186000000 3821000000 -6044000000 -4965000000 -3985000000 -2806000000 558000000 235000000 116000000 11000000 -4552000000 -1189000000 700000000 493000000 3370000000 5878000000 1975000000 0 228000000 646000000 6493000000 2930000000 998000000 938000000 44000000 69000000 -5244000000 -3153000000 778000000 510000000 377000000 5396000000 4246000000 5997000000 464000000 330000000 7075000000 9120000000 -1543000000 196000000 595000000 -2257000000 -56000000 58000000 -1335000000 526000000 6111000000 6637000000 60557000000 226000000 655000000 1897000000 816000000 443000000 333000000 33000000 -87000000 1000000 57000000 60699000000 -29460000000 0 395000000 0 17000000 293000000 -88000000 -398000000 -86000000 -158000000 50000000 4110000000 4165000000 1157000000 1029000000 4451000000 1828000000 -28564000000 32135000000 Note 1 – Basis of Presentation and Consolidation and Recent Accounting Pronouncements Basis of Presentation In the opinion of management, the accompanying balance sheets and related interim statements of income, cash flows, and stockholders' equity include all adjustments, consisting only of normal recurring items, necessary for their fair presentation in conformity with accounting principles generally accepted in the United States of America ("U.S. GAAP"). Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples include: estimates of loss contingencies, product warranties, product life cycles, product returns, and stock-based compensation forfeiture rates; assumptions such as the elements comprising a software arrangement, including the distinction between upgrades/enhancements and new products; when technological feasibility is achieved for our products; the potential outcome of future tax consequences of events that have been recognized in our financial statements or tax returns; estimating the f air value and/or goodwill impairment for our reporting units; and determining when investment impairments are other-than-temporary. Actual results and outcomes may differ from management's estimates and assumptions. Effective July 1, 2008, we began presenting gains and losses resulting from foreign currency remeasurements as a component of other income (expense). Prior to July 1, 2008, we included gains and losses resulting from foreign currency remeasurements as a component of sales and marketing expense. We changed our presentation because this better reflects how we manage these foreign currency exposures and as such gains and losses arising from the remeasurement of foreign currency transactions are incidental to our operations. Prior period amounts have been recast to conform to the current period presentation. See Note 3 – Other Income (Expense). Interim results are not necessarily indicative of results for a full year. The information included in this Form 10-Q should be read in conjunction with information included in the Microsoft Corporation 2008 Form 10-K. Basis of Consolidation The financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments in which we exercise significant influence but do not exercise control and are not the primary beneficiary are accounted for using the equity method. Investments in which we are not able to exercise significant influence over the investee and which do not have readily determinable fair values are accounted for under the cost method. Recently Adopted Accounting Pronouncements On July 1, 2008, we adopted Financial Accounting Standards Board ("FASB") Statement No. 157, Fair Value Measurements ("SFAS No. 157") for all financial assets and liabilities and nonfinancial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). SFAS No. 157 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. See Note 4 – Financial Instruments. Statement of Financial Accounting Standard ("SFAS") No. 159, The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115, became effective for us on July 1, 2008. SFAS No. 159 gives us the irrevocable option to elect fair value for the initial and subsequent measurement for certain financial assets and liabilities on a contract-by-contract basis with the difference between the carrying value before election of the fair value option and the fair value recorded upon election as an adjustment to beginning retained earnings. We chose not to elect the fair value option. 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 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 believe the adoption of SFAS No. 161 will not have a material impact on our financial statements. In February 2008, the FASB issued FASB Staff Position 157-2, Effective Date of FASB Statement No. 157, which delays the effective date of SFAS No. 157 to July 1, 2009 for us, 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). We believe the adoption of the delayed items of SFAS No. 157 will not have a material impact 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 net income 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 net income. 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 believe the adoption of SFAS No. 160 will not have a material impact on our financial sta tements. Note 2 – Earnings Per Share Basic earnings per share is computed on the basis of the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed on the basis of the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options and stock awards, some of which are performance-based. Components of basic and diluted earnings per share were as follows: The following shares attributable to outstanding stock options were excluded from the calculation of diluted earnings per share because their inclusion would have been anti-dilutive. 99000000 133000000 136000000 137000000 Note 3 – Other Income (Expense) Effective July 1, 2008, we began presenting gains and losses resulting from foreign currency remeasurements as a component of other income (expense). Prior to July 1, 2008, we included gains and losses resulting from foreign currency remeasurements as a component of sales and marketing expense. We changed our presentation because this better reflects how we manage these foreign currency exposures and as such gains and losses arising from the remeasurement of foreign currency transactions are incidental to our operations. For the three months ended September 30, 2008, $179 million of losses were reported as other income (expense). For the three months ended September 30, 2007, $69 million of gains were previously recorded as a component of sales and marketing expense and have been recast as other income (expense). Net recognized gains on investments, which included other-than-temporary impairments of $72 million during the first quarter of fiscal year 2009 as compared with $15 million during the first quarter of fiscal year 2008, decreased primarily due to declines in debt and equity values as a result of continuing credit market stresses and stock market declines. In evaluating when declines in fair value are other than temporary, we consider all available evidence, including market declines subsequent to the period-end. 207000000 239000000 129000000 151000000 -165000000 36000000 -179000000 80000000 0 -139000000 Note 4 – Financial Instruments We adopted SFAS No. 157 on July 1, 2008 for all financial assets and liabilities and nonfinancial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). SFAS No. 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS No. 157 defines fair value as the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date and in the principal or most advantageous market for that asset or liability. The fair value should be calculated based on assumptions that market participants would use in pricing the asset or liability, not on assumptions specific to the entity. In addition, the fair value of liabilities should include consideration of non-performance risk including our own credit risk. In addition to defining fair value, SFAS No. 157 expands the disclosure requirements around fair value and establishes a fair value hierarchy for valuation inputs. The hierarchy prioritizes the inputs into three levels based on the extent to which inputs used in measuring fair value are observable in the market. Each fair value measurement is reported in one of the three levels which is determined by the lowest level input that is significant to the fair value measurement in its entirety. These levels are: * Level 1 – inputs are based upon unadjusted quoted prices for identical instruments traded in active markets. * Level 2 - inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities. * Level 3 - inputs are generally unobservable and typically reflect management's estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques that include option pricing models, discounted cash flow models, and similar techniques. The following section describes the valuation methodologies we use to measure different financial assets and liabilities at fair value. Investments Other Than Derivatives Investments other than derivatives primarily include U.S. government and agency securities, foreign government bonds, mortgage-backed securities, corporate notes and bonds, and common stock and equivalents. In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine fair value. This pricing methodology applies to our Level 1 investments such as domestic and international equities, U.S. treasuries, exchange-traded mutual funds, and agency securities. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. These investments are included in Level 2 and consist primarily of corporate notes and bonds, foreign government bonds, mortgage-backed securities, and certain agency securities. Our Level 3 assets within investments other than derivatives primarily include investments in certain corporate bonds. We value the Level 3 corporate bonds using internally developed valuation models, whose inputs include interest rate curves, credit spreads, stock prices, and volatilities. Unobservable inputs used in these models are significant to the fair value of the investments. Derivatives In general, and where applicable, we use quoted prices in an active market for identical derivative assets and liabilities that are traded on exchanges. These derivative assets and liabilities are included in Level 1. The fair values for the derivative assets and liabilities included in Level 2 are estimated using industry standard valuation models, such as the Black-Scholes model. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, foreign exchange rates, and forward and spot prices for currencies and commodities. Level 2 derivative assets and liabilities primarily include certain over-the-counter options, futures, and swap contracts. In certain cases, market-based observable inputs are not available and we use management judgment to develop assumptions which are used to determine fair value. These derivative assets and liabilities are included in Level 3 and primarily represent derivatives for foreign equities and bonds. Assets and Liabilities Measured at Fair Value on a Recurring Basis The following table presents our assets and liabilities measured at fair value on a recurring basis at September 30, 2008. Changes in Level 3 Instruments Measured at Fair Value on a Recurring Basis The following table presents the changes in Level 3 instruments measured on a recurring basis for the three months ended September 30, 2008. The majority of our Level 3 instruments consist of investment securities classified as available-for-sale with changes in fair value included in other comprehensive income. Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis We measure certain assets, including our cost and equity method investments, at fair value on a nonrecurring basis. These assets are recognized at fair value when they are deemed to be other-than-temporarily impaired. During the three months ended September 30, 2008, we did not record any other-than-temporary impairments on those assets required to be measured at fair value on a nonrecurring basis. 1009000000 54000000 0 0 1063000000 0 2522000000 0 0 2522000000 0 387000000 0 0 387000000 770000000 1335000000 0 0 2105000000 416000000 2904000000 0 0 3320000000 0 3971000000 0 0 3971000000 0 2541000000 111000000 0 2652000000 0 202000000 0 0 202000000 3349000000 4000000 4000000 0 3357000000 0 28000000 0 0 28000000 9000000 1268000000 15000000 -414000000 878000000 5553000000 15216000000 130000000 -414000000 20485000000 21000000 395000000 0 -400000000 16000000 138000000 8000000 71000000 217000000 -9000000 -4000000 48000000 35000000 -29000000 0 0 -29000000 0 0 -104000000 -104000000 11000000 0 0 11000000 111000000 4000000 15000000 130000000 -9000000 -3000000 1000000 -11000000 Note 5 – Inventories Components of inventories were as follows: 402000000 417000000 58000000 31000000 1180000000 537000000 Note 6 – Acquisitions We acquired four entities during the three months ended September 30, 2008 for total consideration of $385 million. As a result of these acquisitions, we recorded $312 million of goodwill. All of the entities have been consolidated into our results of operations since their respective acquisition dates. The purchase price allocations for these acquisitions are preliminary for up to 12 months after the acquisition date and subject to revision as more detailed analyses are completed and additional information about fair value of assets and liabilities becomes available. Any change in the estimated fair value of the net assets of the acquired companies will change the amount of the purchase price allocable to goodwill. Pro forma results of operations have not been presented because the effects of these acquisitions, individually and in aggregate, were not material to our consolidated results of operations. Note 7 – Goodwill None of the amount recorded as goodwill is expected to be deductible for tax purposes. The purchase price allocations for all of the acquisitions is preliminary for up to 12 months after the acquisition date and subject to revision as more detailed analyses are completed and additional information about fair value of assets and liabilities becomes available. Any change in the fair value of the net assets of the acquired companies will change the amount of the purchase price allocable to goodwill. Any change in the goodwill amounts resulting from foreign currency translations are presented as "other" in the above table. 153000000 738000000 6274000000 4191000000 752000000 0 233000000 55000000 0 24000000 312000000 0 0 -21000000 -108000000 0 -129000000 153000000 971000000 6308000000 4083000000 776000000 Note 8 – Intangible Assets The components of finite-lived intangible assets were as follows: Acquired intangibles are generally amortized on a straight-line basis over their weighted average lives. Intangible assets amortization expense was $140 million for the three months ended September 30, 2008 as compared with $102 million for the three months ended September 30, 2007. The following table outlines the estimated future amortization expense related to intangible assets as of September 30, 2008: 140000000 102000000 1074000000 1677000000 171000000 708000000 3630000000 796000000 672000000 65000000 124000000 1657000000 278000000 1005000000 106000000 584000000 1973000000 1072000000 1744000000 171000000 706000000 3693000000 811000000 759000000 72000000 152000000 1794000000 261000000 985000000 99000000 554000000 1899000000 421000000 513000000 425000000 289000000 251000000 1899000000 Note 9 – Income Taxes Tax contingencies and other tax liabilities were $4.5 billion as of September 30, 2008 and $3.8 billion as of June 30, 2008, and were included in other long-term liabilities. The effective tax rates were 27% and 31% for the three months ended September 30, 2008 and 2007, respectively. The fiscal year 2009 rate reflected a decline in the recurring effective tax rate primarily as a result of foreign earnings taxed at lower rates. During the first quarter of fiscal year 2009, we paid the Internal Revenue Service ("IRS") approximately $3.1 billion as a result of our settlement with the IRS on its 2000-2003 examination. 0.27 0.31 Note 10 – Unearned Revenue The components of unearned revenue were as follows: 10738000000 12232000000 1225000000 1396000000 1514000000 1669000000 2402000000 2738000000 4424000000 5007000000 6204000000 7101000000 447000000 451000000 13477000000 15297000000 Note 11 – Short-Term Debt In September 2008, our Board of Directors authorized debt financings of up to $6.0 billion. Pursuant to the authorization, we established a commercial paper program providing for the issuance and sale of up to $2.0 billion in short-term commercial paper. As of September 30, 2008, substantially all of the commercial paper was issued and outstanding with a weighted average interest rate, including issuance cost, of 1.42%, and maturities of seven to 14 days. In September 2008, we also entered into a $2.0 billion senior unsecured credit facility, principally to support the commercial paper program. As of September 30, 2008, we were in compliance with the only financial covenant in the credit agreement, which requires us to maintain a coverage ratio of at least three times earnings before interest, taxes, depreciation and amortization to interest expense. The credit facility expires on March 22, 2009. No amounts were drawn against the credit facility during the three months ended September 30, 2008. Note 12 – Contingencies Government competition law matters. In March 2004, the European Commission issued a competition law decision that, among other things, ordered us to license certain Windows server protocol technology to our competitors. In March 2007, the European Commission issued a statement of objections claiming that the pricing terms we proposed for licensing the technology as required by the March 2004 decision were "not reasonable." Following additional steps we took to address these concerns, the Commission announced on October 22, 2007 that we were in compliance with the March 2004 decision and that no further penalty should accrue after that date. On February 27, 2008, the Commission issued a fine of $1.4 billion (€899 million) relating to the period prior to October 22, 2007. In January 2008, the Commission announced that it was opening two new competition law investigations. These investigatio ns relate primarily to interoperability with respect to our Microsoft Office family of products and the inclusion of various capabilities in our Windows operating system software, including Web browsing software. These investigations were precipitated by complaints filed with the Commission by a trade association of Microsoft's competitors and a firm that offers Web browsing software. In May 2008, we filed an application with the European Court of First Instance to annul the February 2008 fine. We paid the $1.4 billion (€899 million) fine in June 2008. We are subject to a Consent Decree and Final Judgment that resolved lawsuits brought by the U.S. Department of Justice, 18 states, and the District of Columbia in two separate actions. The Consent Decree imposed various constraints on our Windows operating system businesses. Portions of the Consent Decree were scheduled to expire on January 31, 2008; we voluntarily agreed to extend other elements of the Consent Decree to November 2009. In October 2007, some states filed a motion with the U.S. District Court for the District of Columbia seeking to have most of the remaining provisions of the Final Judgment in the action to which they are party extended for five years. The U.S. Department of Justice and other states advised the Court that they would not seek any extension of the Final Judgments to which they are party. In January 2008, the court issued a decision granting the states' motion to extend these additional provisions of the consent decree until November 2009. In other ongoing investigations, various foreign governments and several state attorneys general have requested information from us concerning competition, privacy, and security issues. Antitrust, unfair competition, and overcharge class actions. A large number of antitrust and unfair competition class action lawsuits have been filed against us in various state, federal, and Canadian courts on behalf of various classes of direct and indirect purchasers of our PC operating system and certain other software products. We obtained dismissals of damages claims of indirect purchasers under federal law and in 15 states. Courts refused to certify classes in two additional states. We have reached agreements to settle all claims that have been made to date in 19 states and the District of Columbia. Under the settlements, generally class members can obtain vouchers that entitle them to be reimbursed for purchases of a wide variety of platform-neutral computer hardware and software. The total value of vouchers that we may issue varies by state. We will make available to certain schools a percentage of those vouchers that are not issued or claimed (one-half to two-thirds depending on the state). The total value of vouchers we ultimately issue will depend on the number of class members who make claims and are issued vouchers. The maximum value of vouchers to be issued is approximately $2.7 billion. The actual costs of these settlements will be less than that maximum amount, depending on the number of class members and schools that are issued and redeem vouchers. The settlements in all states have received final court approval. Cases in Arizona, Mississippi, and Canada have not been settled. We estimate the total cost to resolve all of these cases will range between $1.7 billion and $1.9 billion. The actual cost depends on factors such as the quantity and mix of products for which claims will be made, the number of eligible class members who ultimately use the vouchers, the nature of hardware and software that is acquired using the vouchers, and the cost of administering the claims. At September 30, 2008, we have recorded a liability related to these claims of approximately $900 million, which reflects our estimated exposure of $1.7 billion less payments made to date of approximately $800 million, mostly for administrative expenses, vouchers, and legal fees. Other antitrust litigation and claims. In November 2004, Novell, Inc. filed a complaint in U.S. District Court, asserting antitrust and unfair competition claims against us related to Novell's ownership of WordPerfect and other productivity applications during the period between June 1994 and March 1996. This case was transferred to Maryland. In June 2005, the trial court granted our motion to dismiss four of six claims of the complaint. Both parties appealed, and in October 2007, the court of appeals affirmed the decision of the trial court, and remanded the case to that court for further proceedings. Patent and intellectual property claims. We are vigorously defending more than 45 patent infringement cases. Microsoft and Alcatel-Lucent are parties to a number of legal proceedings relating to certain patents of each of the companies. Some of these actions began before the merger of Alcatel and Lucent in 2006. For simplicity, we refer to the post-merger entity of Alcatel-Lucent throughout this discussion. * In 2003, we filed an action in U.S. District Court in California seeking a declaratory judgment that we do not infringe certain Alcatel-Lucent patents. Alcatel-Lucent has asserted claims under these patents against computer manufacturers that sell computers with our operating system and application software pre-installed. In February 2007, the jury returned a verdict in Alcatel-Lucent's favor in the first of a series of patent trials, and awarded $1.5 billion in damages. In August 2007, on our motions for judgment as a matter of law, the trial court overturned the jury verdict and dismissed plaintiff's claims on multiple grounds. Alcatel-Lucent appealed, and in September 2008, the court of appeals affirmed the trial court's dismissal of the claim. The trial court previously dismissed Alcatel-Lucent's claims with respect to a second group of patents and two patents in a third grouping. In April 2008, a jury returned a verdict in Alcatel-Lucent's favor in a trial on a consolidated group of one video and thre e user interface patents. The jury concluded that Microsoft had infringed two user interface patents and awarded $367 million in damages. On June 19, 2008, the trial judge increased the amount of damages to $512 million, which includes the $367 million of damages and $145 million of interest. Microsoft has appealed the verdict. * In March 2006, Alcatel-Lucent filed a lawsuit against us in U.S. District Court in California, claiming Windows Vista, Windows Media Player, and the Xbox 360 infringe one of its patents. The Alcatel-Lucent patent, together with five other patents, was then assigned to a separate entity, the Multimedia Patent Trust ("MPT"). Alcatel-Lucent created the MPT immediately prior to the companies' merger and transferred these patents to the trust. In response, we asserted counterclaims that Alcatel-Lucent infringes 10 Microsoft patents by its sale of various products. The case went to trial in April 2008 on Alcatel-Lucent's video patent and four Microsoft counterclaim patents. The jury returned a verdict in Microsoft's favor on June 4, 2008, finding no infringement of Alcatel-Lucent's patent. The jury also found no infringement of Microsoft's counterclaim patents. Microsoft and MPT have now settled all claims relating to the asserted patent and the four remaining patents owned by MPT. * In November 2006, Alcatel-Lucent filed two patent infringement cases against us in U.S. District Court in Texas, asserting Mediaroom and various networking functionalities violate seven of its patents. In April 2007, we asserted infringement counterclaims based on four of our patents relating to functionality similar to that accused by Alcatel-Lucent. The trial on some of these patents is set for January 2009 and trial on the remaining patents is set for March 2009. * In February 2007, we filed a complaint against Alcatel-Lucent with the International Trade Commission claiming Alcatel-Lucent is infringing four Microsoft patents related to our unified communications technology and seeking to prevent the import into the U.S. of certain Alcatel-Lucent unified communications products. Trial of this matter took place in October 2007. The administrative law judge ruled that Alcatel-Lucent infringed one of the four asserted patents. The Commission reversed that decision in May 2008. We have appealed that ruling to the U.S. Court of Appeals for the Federal Circuit. * In April 2007, MPT filed a complaint against Microsoft, Dell, and Gateway in San Diego, California accusing the parties of infringing three video-related patents that Alcatel-Lucent had transferred to MPT. This lawsuit has now been dismissed pursuant to the settlement between Microsoft and MPT. The actual costs to resolve these cases will depend upon many factors such as the outcome of post-trial motions, any appeals, and the results of the remaining trials. Adverse outcomes in some or all of the matters described in this section may result in significant monetary damages or injunctive relief against us that would adversely affect distribution of our operating system or application products. We may enter into material settlements because of these risks. Other. We are also subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact on our financial position, our results of operations, or our cash flows, these matters are subject to inherent uncertainties and management's view of these matters may change in the future. As of September 30, 2008, we had accrued aggregate liabilities of approximately $500 million in other current liabilities and approximately $600 million in other long-term liabilities for all of the contingent matters described in this note. While we intend to vigorously defend these matters, there exists the possibility of adverse outcomes that we estimate could be up to $2.3 billion in aggregate beyond recorded amounts. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact on our financial position, results of operations, and cash flows for the period in which the effects become reasonably estimable. 500000000 600000000 2300000000 Note 13 – Product Warranties 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 estimated life of the software. We regularly reevaluate our estimates to assess the adequacy of the recorded warranty liabilities and adjust the amounts as necessary. The changes in our aggregate product warranty liabilities were as follows: 692000000 32000000 -14000000 -140000000 570000000 Note 14 – Stockholders' Equity Share Repurchases On September 22, 2008, we announced the completion of the two repurchase programs approved by our Board of Directors during the first quarter of fiscal year 2007 to buy back up to $40.0 billion of Microsoft common stock. On September 22, 2008, we also announced that our Board of Directors approved a new share repurchase program authorizing up to $40.0 billion in share repurchases with an expiration date of September 30, 2013. As of September 30, 2008, approximately $36.7 billion remained of the $40.0 billion approved repurchase amount. All repurchases were made using cash resources. The repurchase program may be suspended or discontinued at any time without notice. Of the 223 million shares repurchased, 101 million shares were repurchased for $2.7 billion under the repurchase plan approved by our Board of Directors during the first quarter of fiscal year 2007 and 122 million shares were repurchased for $3.3 billion under the repurchase plan approved by our Board of Directors in September 2008. Dividends The estimate of the amount to be paid as a result of the September 22, 2008 declaration was included in other current liabilities as of September 30, 2008. 223000000 81000000 5966000000 2349000000 2007-09-12 2007-11-15 1034000000 2007-12-13 2008-09-22 2008-11-20 1166000000 2008-12-11 Note 15 – Segment Information SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, establishes standards for reporting information about operating segments. This standard requires segmentation based on our internal organization and reporting of revenue and operating income based upon internal accounting methods. Our financial reporting systems present various data for management to operate the business, including internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. The segments are designed to allocate resources internally and provide a framework to determine management responsibility. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is our Chief Executive Officer. Our five segments are Client; Server and Tools; O nline Services Business; Microsoft Business Division; and Entertainment and Devices Division. We have recast certain prior period amounts to conform to the way we internally managed and monitored performance at the segment level during the current period. Because of our integrated business structure, operating costs included in one segment may benefit other segments, and therefore these segments are not designed to measure operating income or loss directly related to the products included in each segment. Inter-segment cost commissions are estimated by management and used to compensate or charge each segment for such shared costs and to incent shared efforts. Management will continually evaluate the alignment of product development organizations, sales organizations, and inter-segment commissions for segment reporting purposes, which may result in changes to segment allocations in future periods. Reconciling amounts include adjustments to conform with U.S. GAAP and corporate-level activity not specifically attributed to a segment. Significant internal accounting policies that differ from U.S. GAAP relate to revenue recognition, income statement classification, and accelerated amortization for depreciation, stock awards, and performance-based stock awards. In addition, certain revenue and expenses are excluded from segments or included in corporate-level activity, including certain legal settlements and accruals for legal contingencies. 4048000000 4049000000 3405000000 2903000000 770000000 665000000 4947000000 4113000000 1814000000 1929000000 77000000 103000000 3068000000 3264000000 1081000000 880000000 -521000000 -268000000 3260000000 2714000000 134000000 139000000 -1023000000 -880000000 -1428000000 -1098000000 263000000 209000000 173000000 97000000 -31000000 -88000000 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Certain statements in Management's Discussion and Analysis ("MD&A"), other than purely historical information, including estimates, projections, statements relating to our business plans, objectives, and expected operating results, and the assumptions upon which those statements are based, are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements generally are identified by the words "believe," "project," "expect," "anticipate," "estimate," "intend," "strategy," "plan," "may," "should," "will," "would," "will be," "will continue," "will likely result," and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties, which may cause actual results to differ materially from the forwar d-looking statements. A detailed discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section titled "Risk Factors" (refer to Part II, Item 1A). We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events, or otherwise. OVERVIEW 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 personal computers, servers, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutions applications; high-performance computing applications; software development tools; and video games. We provide consulting and product 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 Onlin e, 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. All growth and percentage comparisons refer to the three months ended September 30, 2008, as compared with the three months ended September 30, 2007, unless otherwise noted. 0.09 0.03 0.07 Revenue growth was driven primarily by increased licensing of the 2007 Microsoft Office system and increased revenue associated with Windows Server and SQL Server. Foreign currency exchange rates accounted for a $439 million or three percentage point increase in revenue during the three months ended September 30, 2008. Operating income increased primarily reflecting increased revenue, partially offset by increased headcount-related expenses and increased cost of revenue. Headcount-related expenses increased 22%, reflecting a 14% increase in headcount during the past 12 months and an increase in salaries and benefits for existing headcount. Cost of revenue increased $173 million or 6%, 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 manufacturing costs. Diluted earnings per share growth was impacted favorably by share repurchases. Demand for our software, services, hardware, and online offerings are correlated with global macroeconomic factors. For the remainder of fiscal year 2009, we expect the economic conditions experienced during the first quarter to broadly continue. We are monitoring economic conditions and have three major areas of focus: continuing to provide high value products at the lowest total cost of ownership, increasing focus on our expense management, and prioritizing our investment dollars in key strategic opportunities to enable us to manage our business for the long term. SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS) Revenue and operating income (loss) amounts in this section are presented on a basis consistent with accounting principles generally accepted in the United States of America ("U.S. GAAP") and include certain reconciling items attributable to each of the segments. Segment information appearing in Note 15 – Segment Information is presented on a basis consistent with our current 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 segment operating results and is analyzed separately. Prior period amounts have been recast to conform to the way we internally managed and monitored performance at the segment level during the current period. 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 l icensed ("OEM premium mix"), changes in the geographic mix, and changes in the channel mix of products sold by large, multi-national OEMs versus those sold by local and regional system builders. Client revenue increased reflecting growth in licensing of Windows Vista. Revenue from commercial and retail licensing of Windows operating systems increased $125 million or 22%. OEM revenue decreased $46 million or 1% while OEM license units increased 8%. The decline in OEM revenue reflected the four percentage point decrease in the OEM premium mix to 71% as well as changes in the geographic and product mixes. Based on our estimates, total worldwide PC shipments from all sources grew 10% to 12%, driven by demand in both emerging and mature markets. Client operating income decreased reflecting increased sales and marketing expenses, research and development expenses, and cost of revenue, partially offset by increased revenue. Sales and marketing expenses increased $123 million or 43%, primarily reflecting increased advertising and marketing campaigns. Research and development expenses increased $45 million or 20% as a result of increased headcount-related expenses. Cost of revenue increased $31 million or 14%, primarily driven by product and services costs. For the remainder of fiscal year 2009, we expect PC shipments will grow between 8% and 12%. Within the overall PC market, we expect current trends to continue. 4218000000 4139000000 0.02 3267000000 3388000000 -0.04 Server and Tools concentrates on licensing products, applications, tools, content, and services that are designed to 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. Server and Tools revenue increased reflecting growth in product and services revenue and included a favorable impact from foreign currency exchange rates of $130 million or four percentage points. Server and server application revenue (including CAL revenue) and developer tools revenue increased $395 million or 17%, primarily driven by growth in volume licensing of Windows Server and SQL Server products. This growth reflects continued broad adoption of the Windows Platform and applications with the releases of Windows Server 2008 during the second half of fiscal year 2008 and the release of SQL Server 2008 during the first quarter of fiscal year 2009. Consulting and Premier and Professional product support services revenue increased $111 million or 19%, 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 cost of revenue, research and development expenses, and sales and marketing expenses. Cost of revenue increased $119 million or 20%, reflecting the growth in consulting and Premier and Professional product support services delivered. Research and development expenses increased $93 million or 22%, primarily driven by increased headcount-related expenses. Sales and marketing expenses increased $83 million or 10%, due to higher expenses associated with our corporate sales force. For the remainder of fiscal year 2009, we expect continued growth in both product and services revenue driven by strong adoption of our product portfolio and the recognition of deferred revenue from previously signed agreements. 3406000000 2900000000 0.17 1151000000 959000000 0.20 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. During the three months ended September 30, 2007, we completed our acquisition of aQuantive, Inc. ("aQuantive"), a digital marketing business. aQuantive was consolidated into our results of operations starting August 10, 2007, the acquisition date. Amounts during the three months ended September 30, 2008 in cluded three months of aQuantive results whereas amounts during the three months ended September 30, 2007 included aQuantive results only from the acquisition date through the end of the quarter. OSB revenue increased as a result of increased online advertising revenue and incremental aQuantive revenue, partially offset by decreased access revenue. Online advertising revenue increased $72 million or 15%, to $557 million. This increase reflected growth in our existing online advertising business. Agency revenue, which is solely derived from aQuantive, was $98 million during the three months ended September 30, 2008 and $51 million during the three months ended September 30, 2007. Access revenue decreased $20 million or 29%, to $50 million, reflecting continued migration of subscribers to broadband or other competitively-priced service providers. OSB operating loss increased due to increased cost of revenue, sales and marketing expenses, and research and development expenses, partially offset by increased revenue. Cost of revenue increased $183 million or 47%, primarily driven by increased data center and equipment costs, online content expenses, and agency expenses. Sales and marketing expenses increased $54 million or 23%, and research and development expenses increased $54 million or 19%, primarily due to increased headcount-related expenses. For the remainder of fiscal year 2009, we expect revenue to increase over the prior year as a result of investments we have made. We also expect operating expenses to increase as we continue to invest in our long-term strategy. 770000000 671000000 0.15 -480000000 -267000000 0.80 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. MBD revenue increased reflecting growth in licensing of the 2007 Microsoft Office system and included a favorable impact from foreign currency exchange rates of $214 million or five percentage points. Business revenue increased $544 million or 16%, 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 10% increase in Microsoft Dynamics customer billings. Consumer revenue increased $288 million or 36%, reflecting increased sales primarily due to promotional pricing programs for the 2007 Microsoft Office system. MBD operating income increased reflecting growth in revenue, partially offset by increased sales and marketing expenses, cost of revenue, and research and development expenses. Sales and marketing expenses increased $90 million or 11%, reflecting increased expenses associated with our corporate sales force. Cost of revenue increased $64 million or 30%, driven by an increase in consulting service expenses associated with the April 2008 acquisition of Fast Search & Transfer ASA ("FAST"), and online services infrastructure costs. Research and development expenses increased $56 million or 16%, primarily driven by an increase in headcount-related expenses associated with the FAST acquisition. For the remainder of fiscal year 2009, we expect revenue to continue to increase over the prior year as sales of the 2007 Microsoft Office system continue to grow. 4949000000 4117000000 0.20 3311000000 2700000000 0.23 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 Apple's Macintosh computers and Microsoft PC hardware products, and is responsible for all retail sales and marketing for Microsoft Office and the Windows operating systems. EDD revenue decreased primarily due to decreased Xbox platform and PC game revenue, partially offset by increases across other EDD product revenue. Xbox 360 platform and PC game revenue decreased $331 million or 22%, primarily as a result of the $330 million of incremental revenue from the launch of Halo 3 in the first quarter of fiscal year 2008 and decreased revenue per Xbox 360 console as a result of price reductions during the past 12 months. We shipped 2.2 million Xbox 360 consoles during the first quarter of fiscal year 2009, compared with 1.8 million Xbox 360 consoles during the first quarter of fiscal year 2008. Other EDD product revenue increased $216 million or 51%, led by increased sales of application software for Apple's Macintosh computers, the Zune digital music and entertainment platform, and mobile and embedded device platforms. EDD operating income increased primarily due to decreased cost of revenue and sales and marketing expenses, partially offset by increased research and development expenses and decreased revenue. Cost of revenue decreased $251 million or 21%, primarily driven by decreased Xbox 360 manufacturing costs. Sales and marketing expenses decreased $27 million or 10%, reflecting a decrease in product advertising and bad debt expenses. Research and development expenses increased $145 million or 46%, primarily reflecting increased headcount-related expenses associated with the Windows Mobile device platform, driven by recent acquisitions. For the remainder of fiscal year 2009, we expect revenue to be flat or to decrease relative to the prior fiscal year due to year-over-year variations in launches, volumes, mix, and prices across our portfolio of products and services. We expect sustained profitability for fiscal year 2009. 1814000000 1929000000 -0.06 178000000 167000000 0.07 Certain corporate-level activity is not allocated to our segments. Those results include expenses such as 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. Corporate-level expenses increased, primarily reflecting an increase in headcount-related expenses and partner payments. -1428000000 -1098000000 -0.30 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 reflecting increased data center and equipment costs, online content expenses, and costs associated with growth in our consulting services, partially offset by decreased Xbox 360 manufacturing costs. 0.06 0.19 0.19 0.00 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. The increase in research and development expenses was primarily driven by a 24% increase in headcount-related expenses. 0.24 0.15 0.13 0.02 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 primarily as a result of a 19% increase in headcount-related expenses and increased corporate marketing and advertising campaigns. Effective July 1, 2008, we began presenting gains and losses resulting from foreign currency remeasurements as a component of other income (expense). Prior to July 1, 2008, we included gains and losses resulting from foreign currency remeasurements as a component of sales and marketing expense. We changed our presentation because this better reflects how we manage these foreign currency exposures and as such gains and losses arising from the remeasurement of foreign currency transactions are incidental to our operations. For the three months ended September 30, 2008, $179 million of losses were reported as other income (expense). For the three months ended September 30, 2007, $69 million of gains were previously recorded as a component of sales and marketing expense and have been recast as other income (expense). 0.13 0.20 0.19 0.01 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 and other administrative headcount, and legal and other administrative fees. General and administrative expenses increased primarily driven by a 27% increase in headcount-related expenses. 0.24 0.06 0.05 0.01 Other Income (Expense) Dividends and interest income decreased primarily reflecting lower interest rates on our fixed-income investments. Net recognized gains on investments, which included other-than-temporary impairments of $72 million during the first quarter of fiscal year 2009 as compared with $15 million during the first quarter of fiscal year 2008, decreased primarily due to declines in debt and equity values as a result of continuing credit market stresses and stock market declines. Net losses on derivatives increased primarily due to losses on equity, commodity, and interest rate derivatives in the current period as compared to gains in the prior period. Other of $139 million in the prior year included the correction of several immaterial items from prior periods. Effective July 1, 2008, we began presenting gains and losses resulting from foreign currency remeasurements as a component of other income (expense). Prior to July 1, 2008, we included gains and losses resulting from foreign currency remeasurements as a component of sales and marketing expense. We changed our presentation because this better reflects how we manage these foreign currency exposures and as such gains and losses arising from the remeasurement of foreign currency transactions are incidental to our operations. For the three months ended September 30, 2008, $179 million of losses were reported as other income (expense). For the three months ended September 30, 2007, $69 million of gains were previously recorded as a component of sales and marketing expense and have been recast as other income (expense). 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, including market declines subsequent to the period-end. 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 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. 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. Income Taxes Our effective tax rates were 27% and 31% for the three months ended September 30, 2008 and, 2007, respectively. The fiscal year 2009 rate reflected a decline in the recurring effective tax rate primarily as a result of foreign earnings taxed at lower rates. During the first quarter of fiscal year 2009, we paid the Internal Revenue Service ("IRS") approximately $3.1 billion as a result of our settlement with the IRS on its 2000-2003 examination. FINANCIAL CONDITION Cash, cash equivalents, and short-term investments totaled $20.7 billion as of September 30, 2008, compared with $23.7 billion as of June 30, 2008. Equity and other investments were $4.4 billion as of September 30, 2008, compared with $6.6 billion as of June 30, 2008. 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. We invest primarily in short-term securities to facilitate rapid deployment for immediate cash needs. 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 $28.1 billion at September 30, 2008. Our retained deficit is not expected to affect our future ability to operate, pay dividends , or repay our short-term debt 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 determine fair value. This pricing methodology applies to our Level 1 investments such as 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 determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments such as corporate notes and bonds, foreign government bonds, mortgage-backed securities, and certain agency securities. Level 3 investments are valued using internally developed models with unobservable inputs. Assets and liabilities measured using unobservable inputs are an immaterial portion of our portfolio. A majority of our investments are priced by pricing vendors and are generally Level 1 or Level 2 investments as these vendors either provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted price is not available, the investment is not priced by our pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally labeled as Level 2 investments because the brokers price these investments based on similar assets without applying significant adjustments. In addition, all of our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these investments. Our fair value processes include controls that are designed to ensure appropriate fair values are recorded. Such controls include model validation, review of key model inp uts, analysis of period-over-period fluctuations, and independent recalculation of prices where appropriate. While we own certain mortgage- and asset-backed fixed-income securities, our portfolio as of September 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. Unearned Revenue Unearned revenue from volume licensing programs represents customer billings, 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. For certain other licensing arrangements, revenue attributable to undelivered elements, including free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis for Windows XP and previous PC operating systems, is recorded as unearned 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. Other unearned revenue includes services, Microsoft Dynamics business solutions products, Xbox Live subscriptions, advertising, Mediaroom, and other offerings for which we have been paid upfront and earn the revenue when we provide the service or software, or otherwis e meet the revenue recognition criteria. The following table outlines the expected recognition of unearned revenue as of September 30, 2008: 5059000000 3657000000 2301000000 798000000 1662000000 Short-Term Debt In September 2008, our Board of Directors authorized debt financings of up to $6.0 billion. Pursuant to the authorization, we established a commercial paper program providing for the issuance and sale of up to $2.0 billion in short-term commercial paper. As of September 30, 2008, substantially all of the commercial paper was issued and outstanding with a weighted average interest rate, including issuance cost, of 1.42%, and maturities of seven to 14 days. In September 2008, we also entered into a $2.0 billion senior unsecured credit facility, principally to support the commercial paper program. As of September 30, 2008, we were in compliance with the only financial covenant in the credit agreement, which requires us to maintain a coverage ratio of at least three times earnings before interest, taxes, depreciation and amortization to interest expense. The credit facility expires on March 22, 2009. No amounts were drawn against the credit facility during the three months ended September 30, 2008. Cash Flows Cash flow from operations decreased $2.5 billion from the first three months of fiscal year 2008 to $3.4 billion due to payment of approximately $3.1 billion to the Internal Revenue Service as a result of our settlement of the 2000-2003 audit examination. This impact was partially offset by an increase in cash received from customers, including an increase of $1.2 billion from conversion of accounts receivable to cash. Cash used for financing was $5.2 billion in the first three months of fiscal year 2009, an increase of $2.1 billion from the corresponding period in fiscal year 2008. The increase reflected $6.5 billion of common stock repurchases in the three months ended September 30, 2008, compared with $2.9 billion in the first three months of the prior fiscal year and a $418 million decrease in proceeds from issuance of common stock. These impacts were partially offset by a $2.0 billion increase in cash proceeds from our commercial paper program established in the first quarter of fiscal year 2009. Cash from investing was $595 million in the first three months of fiscal year 2009, as compared with cash used for investing of $2.3 billion in the first three months of fiscal year 2008, a change of $2.9 billion. This change reflected a $5.0 billion decrease in cash paid for acquisitions of companies, resulting from the purchase of aQuantive in the first quarter of fiscal year 2008, partially offset by a $1.7 billion decline in cash from securities lending activities. While we have short-term debt as described above, we currently have no long-term debt. Stockholders' equity at September 30, 2008 was $33.6 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. We have operating leases for most U.S. and international sales and support offices and certain equipment. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital resources. On September 22, 2008, we announced the completion of the two repurchase programs approved by our Board of Directors during the first quarter of fiscal year 2007 to buy back up to $40.0 billion of Microsoft common stock. On September 22, 2008, we also announced that our Board of Directors approved a new share repurchase program authorizing up to $40.0 billion in share repurchases with an expiration of September 30, 2013. During the three months ended September 30, 2008, we repurchased a total of 223 million shares for $6.0 billion; 101 million shares were repurchased for $2.7 billion under the repurchase plan approved by our Board of Directors during the first quarter of fiscal year 2007 and 122 million shares were repurchased for $3.3 billion under the repurchase plan approved by our Board of Directors in September 2008. As of September 30, 2008, approximately $36.7 billion remained of the $40.0 billion approved repurchase amount. All repurchases were made using cash resources. The repurchase program may b e suspended or discontinued at any time without notice. We believe existing cash and cash equivalents and short-term investments, together with funds generated from operations, should be sufficient to meet operating requirements, regular quarterly dividends, debt repayment schedules, and planned share repurchases. Our philosophy regarding the maintenance of a balance sheet with a large component of cash and cash equivalents, short-term investments, and equity and other investments, reflects our views on potential future capital requirements relating 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 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 such indemnifications under SFAS No. 5, Accounting for Contingencies, as interpreted by Financial Accounting Standards Board ("FASB") Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others – an interpretation of FASB statements No.5, 57 and 107 and rescission of FASB Interpretation No. 34. 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 such obligations and have not accrued any material liabilities related to such indemnifications in our financial statements. Recently Adopted Accounting Pronouncements On July 1, 2008, we adopted SFAS No. 157, Fair Value Measurements ("SFAS No. 157") for all financial assets and liabilities and nonfinancial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). SFAS No. 157 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. See Note 4 – Financial Instruments. SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115, became effective for us on July 1, 2008. SFAS No. 159 gives us the irrevocable option to elect fair value for the initial and subsequent measurement for certain financial assets and liabilities on a contract-by-contract basis with the difference between the carrying value before election of the fair value option and the fair value recorded upon election as an adjustment to beginning retained earnings. We chose not to elect the fair value option. 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 identi fy 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 fi nancing 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 FASB Interpretation No. 48 ("FIN 48") Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109. 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. Item 3. Quantitative and Qualitative Disclosures About Market Risk We are exposed to foreign currency, interest rate, fixed-income, equity, and commodity price risks. A portion of these risks is hedged, but fluctuations could impact our results of operations, financial position, and cash flows. We hedge a portion of anticipated revenue and accounts receivable exposure to foreign currency fluctuations using a combination of option and synthetic forward contracts. 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. Fixed-income securities and interest rate derivatives are subject primarily to interest rate risk. The portfolio is diversified and structured to minimize credit risk. Securities held in our equity and other investments portfolio and equity derivatives are subject to price risk, and generally are not hedged. However, we use put-call collars to hedge our price risk on certain equity securities that are held primarily for strategic purposes. Commodity derivatives held for the purpose of portfolio diversification are subject to commodity price risk. We use a value-at-risk ("VaR") model to estimate and quantify our market risks. VaR is the expected loss, for a given confidence level, in fair value of our portfolio due to adverse market movements over a defined time horizon. The VaR model is not intended to represent actual losses in fair value, but is used as a risk estimation and management tool. The model used for currencies, equities, and commodities is geometric Brownian motion, which allows incorporation of optionality with regard to these risk exposures. For interest rate risk, exposures such as key rate durations and spread durations are used in calculations that reflect the principle that fixed-income security prices revert to maturity value over time. VaR is calculated by computing the exposures of each holding's market value to a range of over 1,000 equity, fixed-income, foreign exchange, and commodity risk factors. The exposures are then used to compute the parameters of a distribution of potential changes in the total market value of all holdings, taking into account the weighted historical volatilities of the different rates and prices and the weighted historical correlations among the different rates and prices. The VaR is then calculated as the total loss that will not be exceeded at the 97.5 percentile confidence level or, alternatively stated, the losses could exceed the VaR in 25 out of 1,000 cases. Several risk factors are not captured in the model, including liquidity risk, operational risk, credit risk, and legal risk. Certain securities in our equity portfolio are held for strategic purposes. We hedge the value of a portion of these securities through the use of derivative contracts such as put-call collars. In these arrangements, we hedge a security's equity price risk below the purchased put strike and forgo most or all of the benefits of the security's appreciation above the sold call strike. We also hold equity securities for general investment return purposes. The VaR amounts disclosed below are used as a risk management tool and reflect an estimate of potential reductions in fair value of our portfolio. Losses in fair value over the specified holding period can exceed the reported VaR by significant amounts and can also accumulate over a longer time horizon than the specified holding period used in the VaR analysis. VaR amounts are not necessarily reflective of potential accounting losses, including determinations of other-than-temporary losses in fair value in accordance with U.S. GAAP. VaR numbers are shown separately for interest rate, currency rate, equity price, and commodity price risks. These VaR numbers include the underlying portfolio positions and related hedges. We use historical data to estimate VaR. Given the reliance on historical data, VaR is most effective in estimating risk exposures in markets in which there are no fundamental changes or shifts in market conditions. An inherent limitation in VaR is that the distribution of past changes in market risk factors may not produce accurate predictions of future market risk. The following table sets forth the one-day VaR for substantially all of our positions as of and for the three months ended September 30, 2008, and as of June 30, 2008: Total one-day VaR for the combined risk categories was $81 million at September 30, 2008 and $123 million at June 30, 2008. The total VaR is 43% less at September 30, 2008, and 34% less at June 30, 2008, than the sum of the separate risk categories in the above table due to the diversification benefit of the overall portfolio. 29000000 56000000 50000000 8000000 34000000 100000000 45000000 7000000 32000000 69000000 49000000 7000000 36000000 99000000 52000000 8000000 26000000 45000000 45000000 6000000 Item 4. Controls and Procedures Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. There were no changes in our internal control over financial reporting during the quarter ended September 30, 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Item 1. Legal Proceedings See Note 12 – Contingencies of the Notes to Financial Statements (Part I, Item 1) for information regarding legal proceedings in which we are involved. Item 1A. Risk Factors Our operations and financial results are subject to various risks and uncertainties, including those described below, that could adversely affect our business, financial condition, results of operations, cash flows, and the trading price of our common stock. Challenges to our business model may reduce our revenues and operating margins. Our business model has been based upon customers paying a fee to license software that we develop and distribute. Under this license-based software model, software developers bear the costs of converting original ideas into software products through investments in research and development, offsetting these costs with the revenue received from the distribution of their products. Certain "open source" software business models challenge our license-based software model. Open source commonly refers to software whose source code is subject to a license allowing it to be modified, combined with other software and redistributed, subject to restrictions set forth in the license. A number of commercial firms compete with us using an open source business model by modifying and then distributing open source software to end users at nominal cost and earning revenue on complementary services and products. These firms do not bear the full c osts of research and development for the software. Some of these firms may build upon Microsoft ideas that we provide to them free or at low royalties in connection with our interoperability initiatives. To the extent open source software gains increasing market acceptance, our sales, revenue, and operating margins may decline. Another development is the business model under which companies provide content, and software in the form of applications, data, and related services, over the Internet in exchange for revenues primarily from advertising or subscriptions. An example of an advertising-funded business model is Internet search, where providing a robust alternative is particularly important and challenging due to the scale effects enjoyed by a single market dominant competitor. Advances in computing and communications technologies have made this model viable and enabled the rapid growth of some of our competitors. We are devoting significant resources toward developing our own competing software plus services strategies. It is uncertain whether these strategies will be successful. An important element of our business model has been to create platform-based ecosystems on which many participants can build diverse solutions. A competing vertically-integrated model, in which a single firm controls both the software and hardware elements of a product, has been successful with certain consumer products such as personal computers, mobile phones, and digital music players. We also offer vertically-integrated hardware and software products; however, efforts to compete with the vertically integrated model may increase our cost of sales and operating margins. We face intense competition. We continue to experience intense competition across all markets for our products and services. Our competitors range in size from Fortune 100 companies to small, specialized single-product businesses and open source community-based projects. Although we believe the breadth of our businesses and product portfolio is a competitive advantage, our competitors that are focused on narrower product lines may be more effective in devoting technical, marketing, and financial resources to compete with us. In addition, barriers to entry in our businesses generally are low and products, once developed, can be distributed broadly and quickly at relatively low cost. Open source software vendors are devoting considerable efforts to developing software that mimics the features and functionality of our products, in some cases on the basis of technical specifications for Microsoft technologies that we make available. In response to competition, we are developing versions of our products with b asic functionality that are sold at lower prices than the standard versions. These competitive pressures may result in decreased sales volumes, price reductions, and/or increased operating costs, such as for marketing and sales incentives, resulting in lower revenue, gross margins and operating income. We may not be able to adequately protect our intellectual property rights. Protecting our global intellectual property rights and combating unlicensed copying and use of software and other intellectual property is difficult. While piracy adversely affects U.S. revenue, the impact on revenue from outside the U.S. is more significant, particularly in countries where laws are less protective of intellectual property rights. Similarly, the absence of harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Throughout the world, we actively educate consumers about the benefits of licensing genuine products and obtaining indemnification benefits for intellectual property risks, and we educate lawmakers about the advantages of a business climate where intellectual property rights are protected. However, continued educational and enforcement efforts may fail to enhance revenue. Reductions in the legal protection for software intellectual property rights could adversely affect revenue. Third parties may claim we infringe their intellectual property rights. From time to time we receive notices from others claiming we infringe their intellectual property rights. The number of these claims may grow. To resolve these claims we may enter into royalty and licensing agreements on less favorable terms, stop selling or redesign affected products, or pay damages to satisfy indemnification commitments with our customers. Such agreements may cause operating margins to decline. We have made and expect to continue making significant expenditures to settle claims related to the use of technology and intellectual property rights as part of our strategy to manage this risk. We may not be able to protect our source code from copying if there is an unauthorized disclosure of source code. Source code, the detailed program commands for our operating systems and other software programs, is critical to our business. Although we license portions of our application and operating system source code to a number of licensees, we take significant measures to protect the secrecy of large portions of our source code. If an unauthorized disclosure of a significant portion of our source code occurs, we could potentially lose future trade secret protection for that source code. This could make it easier for third parties to compete with our products by copying functionality, which could adversely affect our revenue and operating margins. Unauthorized disclosure of source code also could increase the security risks described in the next paragraph. Security vulnerabilities in our products could lead to reduced revenues or to liability claims. Maintaining the security of computers and computer networks is a critical issue for us and our customers. Hackers develop and deploy viruses, worms, and other malicious software programs that attack our products. Although this is an industry-wide problem that affects computers across all platforms, it affects our products in particular because hackers tend to focus their efforts on the most popular operating systems and programs and we expect them to continue to do so. We devote significant resources to address security vulnerabilities through: * engineering more secure products; * enhancing security and reliability features in our products; * helping our customers make the best use of our products and services to protect against computer viruses and other attacks; * improving the deployment of software updates to address security vulnerabilities; * investing in mitigation technologies that help to secure customers from attacks even when such software updates are not deployed; and * providing customers online automated security tools, published security guidance, and security software such as firewalls, anti-virus, and other security software. The cost of these steps could reduce our operating margins. Despite these efforts, actual or perceived security vulnerabilities in our products could lead some customers to seek to return products, to reduce or delay future purchases, or to use competing products. Customers may also increase their expenditures on protecting their existing computer systems from attack, which could delay adoption of new technologies. Any of these actions by customers could adversely affect our revenue. In addition, actual or perceived vulnerabilities may lead to claims against us. Although our license agreements typically contain provisions that eliminate or limit our exposure to such liability, there is no assurance these provisions will withstand all legal challenges. We are subject to government litigation and regulatory activity that affects how we design and market our products. As a leading global software maker, we receive close scrutiny from government agencies under U.S. and foreign competition laws. Some jurisdictions also provide private rights of action for competitors or consumers to assert claims of anti-competitive conduct. For example, we have been involved in the following actions. Lawsuits brought by the U.S. Department of Justice, 18 states, and the District of Columbia in two separate actions were resolved through a Consent Decree that took effect in 2001 and a Final Judgment entered in 2002. These proceedings imposed various constraints on our Windows operating system businesses. These constraints include limits on certain contracting practices, mandated disclosure of certain software program interfaces and protocols, and rights for computer manufacturers to limit the visibility of certain Windows features in new PCs. We believe we are in full compliance with these rules. However, if we fail to comply with them, additional restrictions could be imposed on us that would adversely affect our business. The European Commission closely scrutinizes the design of high-volume Microsoft products and the terms on which we make certain technologies used in these products, such as file formats, programming interfaces, and protocols, available to other companies. In 2004, the Commission ordered us to create new versions of Windows that do not include certain multimedia technologies and to provide our competitors with specifications for how to implement certain proprietary Windows communications protocols in their own products. The Commission's impact on product design may limit our ability to innovate in Windows or other products in the future, diminish the developer appeal of the Windows platform, and increase our product development costs. The availability of licenses related to protocols and file formats may enable competitors to develop software products that better mimic the functionality of our own products which could result in decreased sales of our products. Government regulatory actions and court decisions such as these may hinder our ability to provide the benefits of our software to consumers and businesses, thereby reducing the attractiveness of our products and the revenues that come from them. New actions could be initiated at any time, either by these or other governments or private claimants, including with respect to new versions of Windows or other Microsoft products. The outcome of such actions, or steps taken to avoid them, could adversely affect us in a variety of ways, including: * We may have to choose between withdrawing products from certain geographies to avoid fines or designing and developing alternative versions of those products to comply with government rulings, which may entail removing functionality that customers want or on which developers rely. * We may be required to make available licenses to our proprietary technologies on terms that do not reflect their fair market value or do not protect our associated intellectual property. * The rulings described above may be cited as a precedent in other competition law proceedings. Our software and services online offerings are subject to government regulation of the Internet domestically and internationally in many areas, including user privacy, telecommunications, data protection, and online content. The application of these laws and regulations to our business is often unclear and sometimes may conflict. Compliance with these regulations may involve significant costs or require changes in business practices that result in reduced revenue. Noncompliance could result in penalties being imposed on us or orders that we stop doing the alleged noncompliant activity. Our business depends on our ability to attract and retain talented employees. Our business is based on successfully attracting and retaining talented employees. The market for highly skilled workers and leaders in our industry is extremely competitive. We are limited in our ability to recruit internationally by restrictive domestic immigration laws. If we are less successful in our recruiting efforts, or if we are unable to retain key employees, our ability to develop and deliver successful products and services may be adversely affected. Effective succession planning is also important to our long-term success. Failure to ensure effective transfer of knowledge and smooth transitions involving key employees could hinder our strategic planning and execution. Delays in product development schedules may adversely affect our revenues. The development of software products is a complex and time-consuming process. New products and enhancements to existing products can require long development and testing periods. Our increasing focus on software plus services also presents new and complex development issues. Significant delays in new product or service releases or significant problems in creating new products or services could adversely affect our revenue. We make significant investments in new products and services that may not be profitable. We have made and will continue to make significant investments in research, development, and marketing for new products, services, and technologies, including Windows Vista, the 2007 Microsoft Office system, Xbox 360, Live Search, Windows Server, Zune, Windows Live, and other software plus services offerings. Investments in new technology are speculative. Commercial success depends on many factors, including innovativeness, developer support, and effective distribution and marketing. If customers do not perceive our latest offerings as providing significant new functionality or other value, they may reduce their purchases of new software products or upgrades, unfavorably impacting revenue. We may not achieve significant revenue from new product and service investments for a number of years, if at all. Moreover, new products and services may not be profitable, and even if they are profitable, operating margins for new products and businesses may not be as high as the margins we have experienced historically. Adverse economic conditions may harm our business. Unfavorable changes in economic conditions, including inflation, recession, or other changes in economic conditions may result in lower corporate information technology spending and adversely affect our revenue. If demand for PCs, servers, and other computing devices declines significantly, or consumer or corporate spending for those products declines, our revenue will be adversely affected. Challenging economic conditions also may impair the ability of our customers to pay for products and services they have purchased. As a result, reserves for doubtful accounts and write-offs of accounts receivable may increase. We maintain an investment portfolio of various holdings, types, and maturities. These investments are subject to general credit, liquidity, market, and interest rate risks, which may be exacerbated by unusual events that have affected global financial markets. If the global credit market continues to deteriorate, our investment portfolio may be impacted and we could determine that some of our investments have experienced an other-than-temporary decline in fair value, requiring an impairment charge that could adversely impact our financial results. We have claims and lawsuits against us that may result in adverse outcomes. We are subject to a variety of claims and lawsuits. Adverse outcomes in some or all of these claims may result in significant monetary damages or injunctive relief that could adversely affect our ability to conduct our business. Although management currently believes resolving all of these matters, individually or in the aggregate, will not have a material adverse impact on our financial position, results of operations, or cash flows, the litigation and other claims are subject to inherent uncertainties and management's view of these matters may change in the future. A material adverse impact on our financial position, results of operations, and cash flows also could occur for the period in which the effect of an unfavorable final outcome becomes probable and reasonably estimable. We may have additional tax liabilities. We are subject to income taxes in the United States and many foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. We regularly are under audit by tax authorities. Although we believe our tax estimates are reasonable, the final determination of tax audits and any related litigation could be materially different from our historical income tax provisions and accruals. The results of an audit or litigation could have a material effect on our financial position, results of operations, or cash flows in the period or periods for which that determination is made. Our vertically-integrated hardware and software products may experience quality or supply problems. Our hardware products such as the Xbox 360 console are highly complex and can have defects in design, manufacture, or associated software. We could incur significant expenses, lost revenue, and reputational harm if we fail to detect or effectively address such issues through design, testing, or warranty repairs. We obtain some components of our hardware devices from sole suppliers. If a component delivery from a sole-source supplier is delayed or becomes unavailable or industry shortages occur, we may be unable to obtain timely replacement supplies, resulting in reduced sales. Either component shortages or excess or obsolete inventory may require us to record charges to cost of revenue. Xbox 360 consoles are assembled in Asia; disruptions in the supply chain may result in console shortages that would affect our revenues and operating margins. These same risks would apply to any other vertically-integrated hardware and software products we may offer. If our goodwill or amortizable intangible assets become impaired we may be required to record a significant charge to earnings. Under generally accepted accounting principles, we review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. Goodwill is tested for impairment at least annually. Factors that may be considered a change in circumstances, indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable, include a decline in stock price and market capitalization, reduced future cash flow estimates, and slower growth rates in our industry. We may be required to record a significant charge in our financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is determined, negatively impacting our results of operations. We operate a global business that exposes us to additional risks. We operate in over 100 countries and a significant part of our revenue comes from international sales. Pressure to make our pricing structure uniform might require that we reduce the sales price of our software in the United States and other countries. Operations outside the United States may be affected by changes in trade protection laws, policies and measures, and other regulatory requirements affecting trade and investment; changes in regulatory requirements for software; social, political, labor or economic conditions in a specific country or region; and difficulties in staffing and managing foreign operations. Although we hedge a portion of our international currency exposure, significant fluctuations in exchange rates between the U.S. dollar and foreign currencies may adversely affect our net revenues. Catastrophic events or geo-political conditions may disrupt our business. A disruption or failure of our systems or operations in the event of a major earthquake, weather event, cyber-attack, terrorist attack, or other catastrophic event could cause delays in completing sales, providing services or performing other mission-critical functions. Our corporate headquarters, a significant portion of our research and development activities, and certain other critical business operations are located in the Seattle, Washington area, and we have other business operations in the Silicon Valley area of California, both of which are near major earthquake faults. A catastrophic event that results in the destruction or disruption of any of our critical business or information technology systems could harm our ability to conduct normal business operations and our operating results. Abrupt political change, terrorist activity, and armed conflict pose a risk of general economic disruption in affected countries, which may increase our operating costs. These conditions also may add uncertainty to the timing and budget for technology investment decisions by our customers. Acquisitions and joint ventures may have an adverse effect on our business. We expect to continue making acquisitions or entering into joint ventures as part of our long-term business strategy. These transactions involve significant challenges and risks including that the transaction does not advance our business strategy, that we don't realize a satisfactory return on our investment, or that we experience difficulty in the integration of new employees, business systems, and technology, or diversion of management's attention from our other businesses. These events could harm our operating results or financial condition. Improper disclosure of personal data could result in liability and harm our reputation. We store and process large amounts of personally identifiable information. It is possible that our security controls over personal data, our training of employees and vendors on data security, and other practices we follow may not prevent the improper disclosure of personally identifiable information. Such disclosure could harm our reputation and subject us to liability under laws that protect personal data, resulting in increased costs or loss of revenue. Our software products also enable our customers to store and process personal data. Perceptions that our products do not adequately protect the privacy of personal information could inhibit sales of our products. We may experience outages and disruptions of our online services if we fail to maintain an adequate operations infrastructure. Our increasing user traffic and complexity of our products and services demand more computing power. We have spent and expect to continue to spend substantial amounts to purchase or lease data centers and equipment and to upgrade our technology and network infrastructure to handle increased traffic on our Web sites and to introduce new products and services and support existing services such as Xbox Live, Windows Live, and Office Live. This expansion is expensive, complex, and could result in inefficiencies or operational failures, which could diminish the quality of our products, services, and user experience, resulting in damage to our reputation and loss of current and potential users, subscribers, and advertisers, harming our operating results and financial condition. Other risks that may affect our business. Other factors that may affect our performance may include sales channel disruption, such as the bankruptcy of a major distributor, and our ability to implement operating cost structures that align with revenue growth. 27076694 25.77 27076694 2016000000 78895141 27.25 78895141 2866000000 117497843 26.54 117497843 36748000000 223469678 223469678 (1) Derived from audited financial statements. (a) FASB Interpretation 39, Offsetting of Amounts Related to Certain Contracts, permits the netting of derivative assets and derivative liabilities when a legally enforceable master netting agreement exists. These amounts include fair value adjustments related to our own credit risk and counterparty credit risk. (1) Corporate-level activity excludes stock-based compensation expense and revenue reconciling amounts presented separately in those line items. 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