United States Securities and Exchange Commission

Washington, D.C. 20549

FORM 10-K

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED JUNE 30, 20062008

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM            TO            

 


COMMISSION FILE NUMBER 0-14278

MICROSOFT CORPORATION

 

WASHINGTON 91-1144442
(STATE OF INCORPORATION) (I.R.S. ID)

ONE MICROSOFT WAY, REDMOND, WASHINGTON 98052-6399

(425) 882-8080

Securities registered pursuant to Section 12(b) of the Act:

COMMON STOCK                                         NASDAQ

Securities registered pursuant to Section 12(g) of the Act:

NONE

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x    No¨

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes ¨    Nox

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes x    No¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.¨x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a non-accelerated filer.smaller reporting company. See definitionthe definitions of “large accelerated filer,” “accelerated filerfiler” and large accelerated filer”“smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer x            Accelerated filer ¨            Non-accelerated filer ¨

Large accelerated filer xAccelerated filer ¨Non-accelerated filer ¨Smaller reporting company ¨
(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ¨    Nox

As of December 31, 2005,2007, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $233,926,876,964$287,616,660,928 based on the closing sale price as reported on the NASDAQ National Market System. As of August 18, 2006,July 28, 2008, there were 9,969,991,8009,130,293,074 shares of common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held on November 14, 200619, 2008 are incorporated by reference into Part III.

 



 

 

 


Microsoft Corporation

FORM 10-K

For The Fiscal Year Ended June 30, 20062008

INDEX

 


PART I  
Item 1. Business 3
 Executive Officers of the Registrant 11
Item 1A. Risk Factors 12
Item 1B. Unresolved Staff Comments 1817
Item 2. Properties 1817
Item 3. Legal Proceedings 18
Item 4. Submission of Matters to a Vote of Security Holders 18
PART II  
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities 19
Item 6. Selected Financial Data 20
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 21
Item 7A. Quantitative and Qualitative Disclosures about Market Risk 4140
Item 8. Financial Statements and Supplementary Data 4341
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 74
Item 9A. Controls and Procedures 74
 Report of Management on Internal Control over Financial Reporting 74
 Report of Independent Registered Public Accounting Firm 75
Item 9B. Other Information 76
PART III  
Item 10. Directors, and Executive Officers of the Registrantand Corporate Governance 76
Item 11. Executive Compensation 76
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 76
Item 13. Certain Relationships and Related Transactions, and Director Independence 76
Item 14. Principal AccountantAccounting Fees and Services 76
PART IV  
Item 15. Exhibits and Financial Statement Schedules 77
 Signatures 79

 


 

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Special Note About Forward-Looking Statements

Certain statements in this report, other than purely historical information, including estimates, projections, statements relating to our business plans, objectives and expected operating results, and the assumptions upon which those statements are based, are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially from the forward-looking statements. A detailed discussion of these and other risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section entitled “Risk Factors” (refer to Part I, 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.

PART I

ITEM 1.    BUSINESS

GENERAL

Our mission is to enable people and businesses throughout the world to realize their full potential. We workSince the company was founded in 1975, we have worked to achieve ourthis mission throughby creating technology that transforms the way people work, play, and communicate. Since our founding in 1975, we have been a leader in this transformation. We develop and market software, services, hardware, and solutions that we believe deliver new opportunity,opportunities, greater convenience, and enhanced value to people’s lives. We do business throughout the world and have offices in more than 100 countries.

We generate revenue by developing, manufacturing, licensing, and supporting a wide range of software products and services for many different types of computing devices. Our software products and services include operating systems for servers, personal computers, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutionsolutions applications; high-performance computing applications, andapplications; software development tools.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 games, PC games,entertainment device, and peripherals. Online offerings and information are delivered through ourLive Search, Windows Live, Office Live, andour MSN portals and channels.channels, and the Microsoft Online Services platform which includes offerings for businesses such as Microsoft Dynamics CRM Online, Exchange Hosted Services, Exchange Online, and SharePoint Online. We enable the delivery of online advertising across our broad range of digital media properties and on Live Search through our proprietary adCenter® platform.

We also research and develop advanced technologies for future software products.products and services. We believe that delivering breakthrough innovation and high-value solutions through our integrated software platform is the key to meeting our customers’ needs and to our future growth. We believe that over the past few years we have laidwill continue to lay the foundation for long-term growth by delivering innovative new products and services, creating new opportunities for partners, improving customer satisfaction, putting many of our most significant legal challenges behind us, and improving our internal processes. Our focus is to build on this foundation by continuing to innovate onthrough ongoing innovation in our integrated software platform,platforms; by delivering compelling value propositions to customers,customers; by responding effectively to customer and partner needs,needs; and by continuing to focus internally onemphasize the importance of product excellence, business efficacy, and accountability. Our research and development facilities are located primarily in Redmond, Washington. We also have smaller research facilities in other parts of the United States and around the world, including, but not limited to, China, Denmark, England, India, Ireland, and Israel.

OPERATING SEGMENTS

We have five operating segments: Client, Server and Tools, Online Services Business, Microsoft Business Division, and Entertainment and Devices Division. Our segments provide management with a comprehensive financial view of our key businesses. The segments provide a framework forenable the alignment of strategies and objectives across the development, sales, marketing, and services organizations, and they provide a framework for the timely and rational allocation of development, sales, marketing, and services resources within businesses. The segments also help focus strategic planning efforts on key objectives and initiatives across our businesses.

 

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Due to our integrated business structure, operating costs included in one segment may benefit other segments. Therefore, these segments are not designed to measure operating income or loss that is directly related to the products and services 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 motivate shared effort. Segments should not be viewed as discrete or easily separable businesses.

For the fiscal years covered by this filing, our seven segments were: Client; Server and Tools; Information Worker; Microsoft Business Solutions; MSN; Mobile and Embedded Devices; and Home and Entertainment. See Note 18 – Segment Information of the Notes to Financial Statements for financial information regarding segment reporting. On July 17, 2006, we announced a change in our operating segments reflecting the culmination of the business realignment announced in September 2005. These changes will be effective for fiscal year 2007; the seven segments discussed in this section are presented in the way we internally managed and monitored performance at the business group level in fiscal year 2006, 2005, and 2004.

Client

Client has overall responsibility for the technical architecture, engineering, and product delivery of our Windows product family and is also responsible for our relationships with personal computer manufacturers, including multinational and regional original equipment manufacturers (“OEMs”). The segment includes sales and marketing expenses for the Windows client operating system and product development efforts for the Windows platform. Client revenue growth is correlated with the growth of purchases of personal computers from OEMs that pre-install versions of Windows operating systems becauseas the OEM channel accounts for over 80% of total Client revenue.

The next generationWe released Windows Vista, the most recent version of the Windows operating system, Windows Vista, is under development.in fiscal year 2007. This release concluded a major development phase represents a major investment that we expect will resultbelieve resulted in a significantly more manageable and powerful PC operating system than previously released by Microsoft.compared with prior releases. Windows Vista will includeincludes advances in security, digital media, user interfaces, and other areas that will enhance the user and developer experience.

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.

Products:    Windows Vista, including Home, Home Premium, Ultimate, Business, Enterprise and Starter Edition; Windows XP Professional and Home; Media Center Edition; Tablet PC Edition; and other standard Windows operating systems.

Competition

Client faces strong competition from well-established companies with differing approaches to the PC market. Competing commercial software products, including variants of Unix, are supplied by competitors such as Apple, Computer, Hewlett-Packard, IBM, and Sun Microsystems. The Linux operating system, which is also derived from Unix and is available without payment under a General Public License, has gained some acceptance as competitive pressures lead PC OEMs to reduce costs. costs and new, lower price PC form factors gain adoption. Apple takes an integrated approach to the PC experience and has made inroads in share, particularly in the U.S. and in the consumer segment.

The Windows operating system also faces competition from alternative platforms and new devices that may reduce consumer demand for traditional personal computers. Competitors such as Mozilla offer software that competes with the Internet Explorer Web browsing capabilities of Windows products. Apple Computer, Real Networks,User and others compete with Windows Media Player. usage volumes on mobile devices are increasing around the world relative to the PC.

Our operating system products compete effectively by delivering innovative software, giving customers choice and flexibility, a familiar, easy-to-use interface, compatibility with a broad range of hardware and software applications, and the largest support network for any operating system.

Server and Tools

Server and Tools develops and markets software server products, services, and solutions. Windows Server products, including Windows Server operating systems. Windows ServerServer-based products are integrated server infrastructure and middleware software that are designed to support end-to-end software applications and tools built on the Windows Server 2003 operating system. Windows ServerServer-based products include the server platform including targeted segment solutions, database, storage, management and operations, service-oriented architecture platform, and security applications and collaborationidentity software. The segment also builds standalone and software development lifecycle tools for software architects, developers, testers, and project managers. Server products can be run on-site, in a hosting environment, or in a Web-based environment.

We offer a broad range of consulting services and provide product support services. The segmentservices and industry solutions. We also providesprovide training and certification to developers and information technology professionals about our Server and PCTools and Client platform products. Server and Tools also includes the Enterprise Partner Group, which is responsible for sales, partner management and partner programs for medium and large organizations; and the Public Sector sales and marketing organization.

 

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Approximately half45% of Server and Tools revenue comes from multi-year licensing agreements, one thirdapproximately 25% is purchased through fully packaged product and transactional volume licensing programs, and approximately 10% comes from licenses sold to OEMs. Approximately 15%The remainder of Server and Tools revenue comes from consulting and product support services.

Major releases from Server and Tools in fiscal year 2008 included Windows Server 2008 and Visual Studio 2008. Windows Server 2008 provides virtualization technologies, security enhancements, new Internet tools and infrastructure, and management utilities while Visual Studio 2008 provides rapid application development, team collaboration tools, and advances in building connected applications. In fiscal year 2009, we plan to release Microsoft SQL Server 2008 which will deliver advances in database scalability, performance, security, and policy-based management.

Products and Services:    Windows Server operating system; Microsoft SQL Server; Exchange Server; Microsoft ConsultingEnterprise Services; product support services; Visual Studio; System Center products; Forefront security family of products; and Biz Talk Server, among others.Server; MSDN; and other products and services.

Competition

Our server operating system products face intense competition from a wide variety of server operating systems and server applications, offered by companies with a variety of market approaches. Vertically integrated computer manufacturers such as Hewlett-Packard, IBM, and Sun Microsystems offer their own variantversions of the Unix operating system preinstalled on server hardware. Nearly all computer manufacturers offer server hardware for the Linux operating system. IBM’s endorsementsystem and many contribute to Linux operating system development. The competitive position of Linux has aided the acceptance of Linux as an alternative to Unix and Windows server operating systems. Linux’s competitive position has also benefited from the large number of compatible applications now produced by many leading commercial software developers and non-commercial software developers. A number of companies supply versions of Linux, including Novell and Red Hat. Server virtualization platform providers, such as VMware, are another form of competition for the Windows server operating system.

We have entered into business and technical collaboration agreements with Novell and other Linux providers to build, market, and support a series of solutions to enhance the interoperability of our products with their virtualization, management, and network security solutions, and to provide each other’s customers with patent coverage for their respective products.

We compete in the business of providingto provide enterprise-wide computing solutions with several companies that provideoffer solutions and middleware technology platforms. IBM and Sun Microsystems lead a group of companies focused on the Java 2 Platform Enterprise Edition (J2EE). Commercial software developers that provide competing server applications for PC-based distributed client/server environments include CA, Inc., IBM, and Oracle. Our Web application platform software competes with open source software such as Linux, Apache, MySQL, and PHP, and we compete against Java middleware such as JBoss, Geronimo, and Spring Framework.

Numerous commercial software vendors offer competing commercial software applications for connectivity (both Internet and intranet), security, hosting, and e-business servers. System Center competes with Hewlett-Packard, BMC, CA, Inc., and IBM in the Managementmanagement of ITinformation technology infrastructures, while our Forefront Security competesline of business security products compete with McAfee, Symantec, and Trend Micro in protecting both client and server applications. In addition, IBM has a large installed base of Lotus Notes and cc:Mail, both of which compete with our collaboration and e-mail products. Non-commercial software products, including the widely-deployed Apache Web Server, also compete with our solutions. Our products for software developers compete against offerings from Adobe, BEA Systems, Borland, IBM, Oracle, Sun Microsystems, and other companies. These offerings include open source projects like Eclipse (sponsored by IBM and Oracle). We believe that our server products provide customers with advantages in innovation, performance, total costs of ownership, and productivity by delivering superior applications, development tools, and development environment, compatibility with a broad base of hardware and software applications, security, and manageability.

Information WorkerOnline Services Business

Information WorkerThe 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 Microsoft Office system of programs,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 software solutions designed to increase personal, team, and organization productivity. The Office system offerings generate over 85% of Information Worker revenue. Revenue growth depends on our ability to add value to the core Office product set and tofrom MSN narrowband Internet access subscribers. We continue to expand our productlaunch new online offerings and expect to do so in other information worker areas such as enterprise content management, collaboration, unified messaging, and business intelligence.the future. During fiscal year 2008, we launched new releases of

Approximately 40% of Information Worker revenue has come from multi-year license agreements with large enterprises. Revenues from these licenses generally depend upon the number of information workers in a licensed enterprise. Revenue from this category of agreements is therefore relatively independent of the number of PCs sold in a given year. Consequently, general employment levels, particularly in North America and Europe, significantly affect Information Worker revenue. Approximately 40% of Information Worker revenue comes from new licenses acquired through fully packaged product and volume licensing programs to individual consumers and enterprises of all sizes. Most of this revenue is sensitive to information technology budgets, which often depend on general economic conditions. The remaining approximately 20% of Information Worker revenue comes from licenses to OEMs for new PCs and is affected by the level of PC shipments. The next wave of our flagship product, the 2007 Microsoft Office system, is currently under development.

Products:    Microsoft Office; Microsoft Project; Microsoft Visio; SharePoint Portal Server CAL; Microsoft Live Meeting; One Note; and Office Communication Server.

 

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Competition

Competitors to

Windows Live Search, the Microsoft Office system include many software application vendors such as Apple, Corel, Google, IBM, Novell, Oracle, Red Hat, Sun Microsystems,Windows Live suite of applications and local application developers in Europeservices, and Asia. IBM (Smartsuite) and Corel (WordPerfect Suite) have measurable installed bases with their office productivity products. Apple may distribute certain of their application software products with various models of their PCs. The OpenOffice.org project provides a freely downloadable cross-platform application that also has been adapted by various commercial software vendors to sell under their brands, including IBM, Novell, Red Hat, and Sun. Corel’s suite and many local software suites around the world are aggressively priced for OEMs to preinstall on low-priced PCs.updated our MSN Video Service. In addition, to traditional client-side applications, Web-based offerings such as AjaxWrite, gOffice, iNetOffice, SimDesk, ThinkFree, wikiCalc, or other small projects competing with individual applications, can also provide an alternative to Microsoft Office system products. Google has announced spreadsheet and word processing applications as web-based offeringswe launched a new release of adCenter, our proprietary advertising platform, and also provides an enterprise search offering that competes with SharePoint andexpanded our new enterprise search product. IBM has many different points of competition with Office system products with its Notes and Workplace offerings.advertising platform portfolio through acquisitions.

As we continue to respond to market demand for additional functionality and products, we will compete with additional vendors, most notably in enterprise content management, collaboration tools, unified messaging, and business intelligence. These competitors include WebEx, andWe acquired a number of companies during the fiscal year, the most significant of which was aQuantive, Inc., a digital marketing business intelligence vendors such as Business Objects, Cognos,that we expect will play a key role in the future development of our Online Services Business. We believe the acquisition will help us build and Hyperion.

Microsoft Business Solutions

Microsoft Business Solutions is responsiblesupport next-generation advertiser and publisher solutions for Microsoft Dynamics brand business applications for smallcross media planning, video-on-demand, and mid-size businesses, large organizations and divisions of global enterprises. It offers financial management, customer relationship management, supply chain management, and analytics applications. Revenue is derived from software and services sales, with software sales representing a large majority of total revenue. Software revenues include both new software licenses and enhancement plans, which provide customers with future software upgrades and on-line training over the period of the plan. The solutions are delivered through a worldwide network of channel partners and independent software vendors that provide services, additional related software, and local support.Internet protocol television.

Products:    Microsoft Dynamics AX; Microsoft Dynamics CRM; Microsoft Dynamics GP; Microsoft Dynamics NAV; Microsoft Dynamics SL; Microsoft Dynamics Retail Management System; Microsoft Partner Program; and Microsoft Office Small Business Accounting.

Competition

Our competition varies based upon the size and geographic location of the customer for whom we are competing. We compete with well-known vendors such as Intuit and Sage in the market focused on providing solutions for small and mid-sized businesses. The market for large organizations and divisions of global enterprises continues to be intensely competitive with a small number of primary vendors including Oracle and SAP. Additionally, these large enterprise-focused vendors are repositioning some of their business applications to focus on small and mid-sized businesses. We believe our products compete effectively with these vendors based on our strategy of providing integrated, adaptable solutions that work like and with Microsoft technologies our customers already have.

MSN

MSN provides personal communications services, such as e-mail and instant messaging, and online information offerings such as MSN Search, MapPoint, and the MSN portals and channels around the world. MSN also provides a variety of online paid offerings. MSN manages many of its own properties, including health, autos, and shopping. MSN also creates alliances with third parties for many channels, including CareerBuilder.com, Expedia.com, Foxsports.com, Match.com, and MSNBC.com.

MSN generates revenue primarily from advertisers on MSN, from consumers and partners through subscriptions and transactions, and from MSN narrowband Internet access subscribers. In fiscal year 2006, we launched MSN adCenter – our internally developed advertising platform – in certain international markets and throughout the U.S. where it now serves 100 percent of paid search traffic on our online properties. We believe MSN adCenter will enable us to increase both display and search advertising revenues by reducing our reliance on third parties for delivering

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ads. In fiscal year 2006, we announced Windows Live™, a set of Internet services and software designed to improve the users’ connected experience and we released Windows Live Messenger to consumers in 58 countries.

Products:    MSN Search; MSN; MapPoint; MSN Internet Access; MSN Premium Web Services (consisting of MSN Internet Software Subscription, MSN Hotmail Plus, MSN Bill Pay, and MSN Radio Plus)Software Services); Windows Live; and MSN Mobile Services.Services; AvenueA Razorfish media agency services; Atlas online tools for advertisers; and the Drive PM ad network for publishers.

Competition

MSNOSB competes with AOL, Google, Yahoo!, and a wide array of Web sites and portals that provide content and online offerings of all types to end users. We compete with these organizations to provide advertising opportunities for merchants. MSNOSB also competes for narrowband Internet access users with AOL, Earthlink, and other ISPs for dial-up internetInternet access in the United States. Due to the continuing trend of consumers migrating from narrowband to broadband Internet access, we expect our narrowband Internet access subscriber base to continue to decline as we de-emphasize this portion of our business. The Internet advertising industry has grown significantly over the past several years, and we anticipate that this trend will continue. Competitors are aggressively developing Internet offerings that seek to provide more effective ways of connecting advertisers with audiences through enhanced functionality in communication services, improvements in information services such as Internet search, and improved advertising infrastructure and support services. We have developed our own algorithmic search engine to provide end users with more relevant search results, expanded search services, and a broader selection of content, and expanded search services.content. To support the growth of our advertising business, we also are investing in our communication services, technology, operations, and sales efforts. We will continue to introduce new products and services, including the Windows Live set of services that are aimed at attracting additional users through improvements in the user online experience. As consumers migrate from narrowband to broadband Internet access, we expect our narrowband Internet access subscriber base to continue to decline and this portion of our business to decrease in importance. We believe that we can compete effectively across the breadth of our Internet services by providing users with software innovation in the form of information and communication services that help them find discover, and experience whatuse the information and experiences they want online and by providing merchants with effective advertising results through improved systems and sales support.

Mobile and Embedded DevicesMicrosoft Business Division

MobileMicrosoft Business Division (“MBD”) offerings consist of the Microsoft Office system and Embedded Devices developsMicrosoft Dynamics business solutions. Microsoft Office system products are designed to increase personal, team, and markets products that extendorganization productivity through a range of programs, services, and software solutions. Growth of revenue from the Windows platformMicrosoft Office system offerings, which generate over 90% of MBD revenue, depends on our ability to mobile devicesadd value to the core Office product set and to continue to expand our product offerings in other information worker areas such as PDAscontent management, enterprise search, collaboration, unified communications and phones,business intelligence. Microsoft Dynamics products provide business solutions for financial management, customer relationship management, supply chain management, and to embedded devices. Microsoft’s visionanalytics applications for mobile devices is rooted insmall and mid-size businesses, large organizations, and divisions of global enterprises.

We evaluate MBD results based upon the convergencenature of the computingend user in two primary parts—business revenue which includes Microsoft Office system revenue generated through volume licensing agreements and wireless industries,Microsoft Dynamics revenue, and consumer revenue which we believe creates new opportunities to improve communication and information access for customers. We see software as a key differentiator in making smart devices and wireless data services valuable to customers through rich experiences such as mobile messaging, location-based services, media, and speech recognition. We are working closely with mobile operators and with hardware and software partners to accelerate the development and availability of smart devices and services, and to provide a broad range of choices for customers. The segment is also responsible for managing our company-wideincludes revenue from retail packaged product sales and customer relations with device manufacturersOEM revenue. Approximately 80% of MBD revenue is generated from sales to businesses. Revenue from this category generally depends upon the number of information workers in a licensed enterprise and other communication-sector customers, which includes network service providersis therefore relatively independent of the number of PCs sold in a given year. Approximately 20% of MBD revenue is derived from sales to consumers. Most of this revenue is generated from new licenses acquired through fully packaged products and medialicenses sold through OEMs for new PCs and entertainment companies. Windows Embedded is a suitegenerally affected by the level of operating systems, tools,PC shipments and technologies that are specifically designed for today’s advanced embedded devices.product launches.

Products:    Windows Mobile software platform; Windows Embedded device operating system; and Windows Automotive.Microsoft Office; Microsoft Project; Microsoft Visio; Microsoft Office SharePoint Server; Microsoft PerformancePoint; Microsoft Office Live; FAST ESP; Microsoft Exchange Server; Microsoft Exchange Hosted Services; Microsoft Office Live Meeting; Microsoft Office Communication Server; Microsoft Office Communicator;

Competition

Windows Mobile software faces substantial competition from Nokia, Openwave Systems, Palm, QUALCOMM, Research In Motion, and Symbian. The embedded operating system segment is highly fragmented with many competitive offerings. Key competitors include IBM, Wind River, and versions of embeddable Linux from commercial Linux vendors such as Metrowerks and MontaVista Software. The telematics market is also highly fragmented, with competitive offerings from IBM and automotive suppliers building on various real-time operating system platforms from commercial Linux vendors, QNX Software Systems, Wind River, and others. We believe that our products compete effectively by providing a familiar development framework, which enables developers to easily write and deploy innovative applications for mobile or embedded devices. We also compete by providing a flexible platform that allows customers and partners to build differentiated and profitable business models, and by providing end users with benefits such as ease of use, personal productivity, and better information management and control.

 

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Microsoft Tellme Service, Microsoft Dynamics AX; Microsoft Dynamics CRM; Microsoft Dynamics CRM Online; Microsoft Dynamics GP; Microsoft Dynamics NAV; Microsoft Dynamics SL; Microsoft Dynamics Retail Management System; Microsoft Partner Program; and Microsoft Office Accounting.

Competition

Competitors to the Microsoft Office system include many software application vendors such as Apple, Corel, Google, IBM, Novell, Oracle, Red Hat, Sun Microsystems, and local application developers in Europe and Asia. IBM (Smartsuite) and Corel (WordPerfect Suite) have measurable installed bases with their office productivity products. Apple may distribute certain of its application software products with various models of its PCs. The OpenOffice.org project provides a freely downloadable cross-platform application that also has been adapted by various commercial software vendors to sell under their brands, including IBM, Novell, Red Hat, and Sun. Corel’s suite and many local software suites around the world are aggressively priced for OEMs to preinstall on low-priced PCs. Google has launched Google Apps, a hosted messaging and productivity suite, and also provides an enterprise search offering that competes with Microsoft Office SharePoint Server for Search, our new enterprise search product. Web-based offerings such as AjaxWrite, gOffice, iNetOffice, SimDesk, ThinkFree, wikiCalc, or other small projects competing with individual applications, can also provide an alternative to Microsoft Office system products. IBM has many different points of competition with Office system products with its Notes and Workplace offerings.

As we continue to respond to market demand for additional functionality and products, we will compete with additional vendors, most notably in enterprise content management and search, collaboration tools, unified communications, and business intelligence. These competitors include Autonomy, Cisco, Endeca, Google, IBM, Oracle, and SAP.

Our Microsoft Dynamics products compete with well-known vendors such as Intuit and Sage in the market focused on providing solutions for small and mid-sized businesses. The market for large organizations and divisions of global enterprises is intensely competitive with a small number of primary vendors including Oracle and SAP. These vendors are positioning many of their business applications to focus more intensely on small and mid-sized businesses. Additionally Salesforce.com’s on-demand customer relationship management offerings compete directly with Microsoft Dynamics CRM Online and Microsoft Dynamic CRM’s on-premise offerings. We believe our products compete effectively with these vendors based on our strategy of providing interoperable, adaptable solutions that work well with technologies our customers already have.

HomeEntertainment and EntertainmentDevices Division

HomeThe Entertainment and EntertainmentDevices Division (“EDD”) is responsible for development, production,developing, producing, and marketing for the Xbox video game system, including consoles and accessories, third-party games, games published under the Microsoft brand, and Xbox Live operations, as well as research, and sales, and support.support of those products. In addition to Xbox, we offer several types ofthe Zune digital music and entertainment products, includingdevice; PC software games,games; online games,games; Mediaroom, our Internet protocol television software; mobile and embedded device platforms, Surface computing platform; and other devices. The segmentEDD also leads the development efforts of our Consumer Productivity Experience Group (“CPxG”) which includes Microsoft’s line of consumer software and hardware products such as the Encarta line of learning products and services,including application software for Macintosh computers and Microsoft PC hardware products, such as mice and keyboards. In addition, the segment carries outis responsible for all retail sales and marketing for Microsoft Office and the Windows operating systems (for which it receives an inter-segment commission), Xbox, PC games, and CPxG products. It also is responsible for the development, sales, and deployment of Microsoft’s TV platform products for the interactive television industry, including MSTV Foundation Edition and Internet Protocol TV products.systems.

Products:Xbox 360; Xbox;360 console and games; Xbox Live; CPxG (consumerZune; Mediaroom; numerous consumer software and hardware products)products (such as mice and keyboards); Windows Mobile software and IPTV.services platform; Windows Embedded device operating system; Windows Automotive; and Surface computing platform.

Competition

The homeEntertainment and entertainment business isdevices businesses are highly competitive, characterized by rapid product life cycles, frequent introductions of new products and titles, and the development of new technologies. The markets for our products are characterized by significant price competition. We anticipate continued pricing pressure from our competitors. From time to time, we have responded to this pressure by reducing prices on certain products. Our competitors vary in size from very small companies with limited resources to very large, diversified corporations with substantial financial and marketing resources. We compete primarily on the basis of product innovation, quality and variety, timing of product releases, and effectiveness of distribution and marketing.

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Our Xbox hardware business competes with console platforms from Nintendo and Sony, both of which have a large, established base of customers. The lifecycle for video game consoles averages 5five to 7seven years. We released Xbox 360, our nextsecond generation console, in November 2005. Nintendo and Sony have also announcedreleased new versions of their game consoles which have not been released. Success in late 2006. We believe the transition to the next generationsuccess of video game consoles will depend onis determined by the availability of games for the console, providing exclusive game content that gamers seek, the computational power and reliability of the console, and the ability to create new revenue sources such as advertising and downloadable content. We believethink the Xbox 360 is positioned well against competitive console products based on significant innovation in hardware architecture, new developer tools, expanded revenue sources, and continued strong exclusive content from our own game franchises such as Halo.

In addition to competing against software published for non-Xbox platforms, our games business also competes with numerous companies that we have licensed to develop and publish software for the Xbox consoles. Zune competes with the Apple iPod and other digital music and entertainment devices. Our PC hardware products face aggressive competition from computer and other hardware manufacturers, many of which are also current or potential partners. Our MSTV businessMediaroom faces competition primarily from ad hoc solutionsa variety of competitors that address sub-segmentsprovide elements of the TVan Internet protocol television delivery platform, but that do not provide end-to-end solutions for the network operator. Windows Mobile software and services faces substantial competition from Apple, Nokia, Openwave Systems, Palm, QUALCOMM, Research In Motion, and Symbian. The embedded operating system business is highly fragmented with many competitive offerings. Key competitors include IBM, Wind River, and versions of embeddable Linux from commercial Linux vendors such as Metrowerks and MontaVista Software.

OPERATIONS

To serve the needs of customers around the world and to improve the quality and usability of products in international markets, we “localize” many of our products to reflect local languages and conventions. Localizing a product may require modifying the user interface, altering dialog boxes, and translating text.

Our operational centers support all operations in their regions, including customer contract and order processing, credit and collections, information processing, and vendor management and logistics. The regional center in Ireland supports the EMEAEuropean, Middle Eastern, and African region; the center in Singapore supports the Japan, Greater China and Asia-Pacific region; and the centers in Fargo, North Dakota, Puerto Rico, Redmond, Washington, and Reno, and RedmondNevada support NorthLatin America and LatinNorth America.

We contract most of our manufacturing activities to third parties who produce thefor Xbox 360 and related games, Zune, various retail software packaged products, and Microsoft hardware.hardware to third parties. Our products may include some components that are available from only one or limited sources. Our Xbox 360 console includes certain key components that are supplied by a single source. The central processing unit is purchased from IBM and the graphics chips and embedded dynamic random access memory chips for the graphics processing unit are purchased from Taiwan Semiconductor Manufacturing Company and NEC Corporation, respectively. Although we have chosen to initially source these key Xbox 360 components from

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a single supplier, we are under no obligation to exclusively source components from these vendors in the future. Beyond the exceptions noted, we generally have the ability to use other custom manufacturers if the current vendor becomes unavailable. We generally have multiple sources for raw materials, supplies, and components, and are often able to acquire component parts and materials on a volume discount basis.

PRODUCT DEVELOPMENT

During fiscal years 2006, 2005,2008, 2007, and 2004,2006, research and development expense was $6.58$8.2 billion, $6.10$7.1 billion, and $7.74$6.6 billion, respectively. ThoseThese amounts represented 14.9%14%, 15.3%14%, and 21.0%15%, respectively, of revenue in each of those years. We plan to continue to make significant investmentinvestments in a broad range of research and product development.development efforts.

MostWhile most of our software products are developed internally. Weinternally, we also purchase technology, license intellectual property rights, and oversee third-party development and localization of certain products. We believe we are not materially dependent upon licenses and other agreements with third parties relating to the development of our products. Internal development allows us to maintain closer technical control over our products. It also gives us the freedom to decide which modifications and enhancements are most important and when they should be implemented. Generally, we also create product documentation internally. We strive to obtain information at the earliest as early as

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possible time about changing usage patterns and hardware advances that may affect software design. Before releasing new software platforms, we provide application vendors with a range of resources and guidelines for development, training, and testing.

Investing in Business and Product Development Strategy.Development.    Innovation is a key factor affectingin Microsoft’s growth. In fiscal year 2006,Our model for growth is based on broad adoption of the products and services we receiveddevelop and market, our 5,000th patent.willingness to enter new markets, and our ability to embrace and act on disruptive technology trends. We continue our long-term commitment to research and development, including advanced work aimed at innovationsdevelop, in a wide spectrum of technologies:technologies, tools, and platforms;platforms spanning communication collaboration and expression;collaboration; information access and organization; entertainment; business and e-commerce; and devices. Through innovationsIncreasingly, we are taking a global approach to innovation. While our main research and development facilities are located in these areas,Redmond, Washington, we expectalso operate research facilities in other parts of the United States and around the world, including Canada, China, Denmark, England, India, Ireland, and Israel. This global approach will help us remain competitive in local markets and enables us to grow revenue via three principal strategies:continue to attract top talent from across the globe.

Based on our broad focus on innovation and long-term approach to new markets, we see the following key opportunities for growth:

Strengthening coreConsumer technology.    To build on our strength in the consumer marketplace with Windows Vista, the 2007 Microsoft Office System, Xbox 360, Microsoft Windows Live, Windows Mobile, and Zune, we are focused on delivering products that we believe are compelling and cutting edge in terms of design, features, and functionality. To succeed in consumer technologies, we also are working to define the next era of consumer electronics. In the past, consumer electronics was a hardware-centric business; today, the innovation in consumer electronics devices lies in the software that powers them. This is creating new opportunities for us to deliver end-to-end experiences that connect users to information, communications, entertainment, and people in new and compelling ways.

Software plus services.    Underlying our opportunities in all of our businesses is a company-wide commitment to embrace software plus services. The ability to combine the power of desktop and server software with the reach of the Internet represents an opportunity across every one of our businesses.    The Client, Server & Tools, As we continue to build out our services platform, we will bring a broad range of new products and Information Worker segments remain our largestservice offerings to market that target the needs of large enterprises, small and medium-sized businesses, and continue to grow as a result of growth in personal computerconsumers.

Expanding our presence on the desktop, the server, and server shipments, software upgrades and growth in the market for business software and services. with developers.    We believe the growth inwe are well-positioned to build on our corestrength with businesses will be driven by our forthcoming innovations, including theof all sizes and with developers. Fiscal year 2008 saw widespread adoption of Windows Vista operating system,and the 2007 Microsoft Office system and Exchange Server 2007. We also expect these businesses to be impacted by expected growth in the world’s developing countries, as their economies develop and they adopt global standards for intellectual property protection. In fiscal year 2006, nearly 60 million PCs were sold with pirated versions of Windows. Our Windows Genuine Advantage program and agreements with PC manufacturers in China are just two examples of our commitment to protect our intellectual property. Meanwhile, new payment options like FlexGo, which enables people to finance their computer use on a pay-as-you-go basis, will help us reach new consumers in emerging markets.

Succeeding in adjacent businesses.    In fiscal year 2007, we will deliver new products, services, and technologies that we believe will position us to take advantage of new opportunities. One example is unified communications, which brings together telephony, email, instant messaging, mobile devices, and Web conferencing, in order to streamline the way workers communicate. We believe new enterprise information management tools will help knowledge workers create, find, use, and share business information more quickly and more effectively. In addition, we’ll offer new security capabilities, improved management products, and new development tools. We recently entered the high-performance computing business and we have new offerings and initiatives in industries such as life sciences and manufacturing.

Entering new markets.    We believe new markets, such as online gaming and entertainment services, including IPTV, our digital television technology, provide a number of new opportunities for us.

Leading the Software Services Transformation

Internet-based services are transforming the way people create, deploy, manage and use technology. We are committed to playing a leadership role in the software services transformation through our efforts to create our services platform for the next generation of applications, communications, and commerce. Across the company, software services are at the core of our development efforts.

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In fiscal year 2006, we introduced Windows Live and Office Live, which provides small businesses with affordable Internet-based business services hosted by Microsoft. We rolled out new search services, including beta releaseslaunch of Windows Live SearchServer 2008, SQL Server 2008, and Windows Live Academic Search.Visual Studio 2008. We introduced new and enhanced services for computer safety and computer maintenance (Windows Live SafetyCenter and Windows Live OneCare), communications (Windows Live Mail and Windows Live Messenger), and entertainment (Xbox Live). We also created Live Labs, an applied research program that targets Internet products and services.

Because software services offer strong opportunities for growth, we will continue to refinefocus expanding adoption of these products in fiscal year 2009, and improve adCenter, our advertising engine for Windows Live, MSNin providing additional value in security, messaging, systems management, and other online offerings.collaboration. We will deploy new service-based solutions, including Dynamics CRM Live, which we announced in July 2006. We will also continue to build out our services infrastructure, providingfocus on developers with the release of new tools such as Silverlight. We will continue to help partnerspursue new opportunities in high-performance computing, unified communications, healthcare, and businesses create and host services, and adding new data centers to meet growing consumer demandbusiness intelligence. Emerging markets are also an important opportunity for services.us.

DISTRIBUTION, SALES AND MARKETING

We distribute our products primarily through the following channels: OEM; distributors and resellers; and online.

OEM.    Our operating systems are licensed primarily to OEMs under agreements that grant the OEMs the right to build computing devices based on our operating systems, principally PCs. Under similar arrangements, we also market and license certain server operating systems, desktop applications, hardware devices, and consumer software products to OEMs. We have OEM agreements covering one or more of our products with virtually all of the major PC OEMs, including Acer, Dell, Fujitsu, Fujitsu Siemens Computers, Gateway, Hewlett-Packard, Lenovo, NEC, Samsung, Sony, and Toshiba. A substantial amount of OEM business is also conducted with system builders, which are low-volume, customized PC vendors operating in local markets.

Distributors and Resellers.    We license software to organizations under arrangements that allow the end-user customer to acquire multiple licenses of products. Organizations license our products primarily through large account resellers (“LARs”), direct market resellers, and value-added resellers (“VARs”). Many organizations that license products through enterprise agreements (“EAs”) transact directly with us, with sales support from our Enterprise Software Advisor channel partners. These Enterprise Software Advisors typically are also authorized as LARs and operate as resellers for our other licensing programs. Although each type of reselling partner reaches organizations of all sizes,

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LARs are primarily engaged with large organizations and VARs typically reach the breadth of small- and medium-sized organizations. Some of our distributors include Ingram Micro and Tech Data, and some of our largest resellers include CDW, Dell, Insight Enterprises, Software House International, and Software Spectrum. Our business solutionsMicrosoft Dynamics software offerings are licensed to enterprises through a global network of channel partners providing vertical solutions and specialized services. We distribute our finished goods products primarily through independent non-exclusive distributors, authorized replicators, resellers, and retail outlets. Individual consumers obtain our products primarily through retail outlets, including Best Buy, Target, and Wal-Mart. We have a network of field sales representatives and field support personnel that solicits orders from distributors and resellers and provides product training and sales support.

Our arrangements for organizations to acquire multiple licenses of products are designed to provide them with a means of doing so without having to acquire separate packaged product through retail channels. In delivering organizational licensing arrangements to the market, we use different programs designed to provide flexibility for organizations of various sizes. While these programs may differ in various parts of the world, generally they include:

Open.Open licensing.    Designed primarily for small-to-medium organizations (5 to over 250 licenses), this program allows customers to acquire perpetual licenses and, at the customer’s election, rights to future versions of software products over a specified time period (generally two years). The offering that conveys rights to future versions of certain software product over the contract period is called Software Assurance. Software Assurance also provides support, tools, and training to help customers deploy and use software efficiently. Under the Open program, customers can acquire licenses only, or licenses with Software Assurance. They can also renew Software Assurance upon the expiration of existing volume licensing agreements.

Select.Select licensing.    Designed primarily for medium-to-large organizations (greater than 250 licenses), this program allows customers to acquire perpetual licenses and, at the customer’s election, Software Assurance, which consists of rights to future versions of certain software products, support, tools, and training over a specified time period (generally three years). Similar to the Open program, customers can acquire licenses only, acquire licenses with Software Assurance, or renew Software Assurance upon the expiration of existing volume licensing agreements.

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Enterprise Agreement.Agreement licensing.    The Enterprise Agreement is targeted at medium and large organizations that want to acquire perpetual licenses to software products for all or substantial parts of their enterprise, along with rights to future versions of certain software products, support, tools, and training over a specified time period (generally three years).

Online Services.Online.    We distribute online content and services through Live Search, Windows Live, Office Live, our MSN portals and channels, the Microsoft Online Services platform, which includes offerings for business, and other online channels. MSNOSB delivers Internet access and various premium services and tools to consumers. MSNOSB also delivers online e-mailemail and messaging communication services and information services such as online search, advertising, and premium content. Home and EntertainmentEDD operates the Xbox Live service which allows customers to participate in the gaming experience online with other subscribers online. Microsoft Business Solutions operatessubscribers. We operate and deliver the Microsoft Small Business Center portal, which is delivered online.portal. This portal provides tools and expertise for small-business owners to build, market, and manage their businesses online. Other services delivered online include Microsoft Developer Networks subscription content and updates, periodic product updates, and online technical and practice readiness resources to support our partners in developing and selling our products and solutions.

CUSTOMERS

Our customers include individual consumers, small and medium-sized organizations, enterprises, governmental institutions, educational institutions, Internet Service Providers,service providers, application developers, and OEMs. Consumers and small- and medium-sized organizations obtain our products primarily through resellers and OEMs. No sales to an individual customer accounted for more than 10% of fiscal year 2008 or 2007 revenue. Sales to Dell and its subsidiaries in the aggregate accounted for approximately 11% of fiscal year 2006 and 10% in each of fiscal year 2005 and 2004 revenue. These sales were made primarily through our OEM and volume licensing channels and cover a broad array of products including Windows PC operating systems, Microsoft Office, and server products. Our practice is to ship our products promptly upon receipt of purchase orders from customers; consequently, backlog is not significant.

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EXECUTIVE OFFICERS OF THE REGISTRANT

Our executive officers as of August 25, 2006July 31, 2008 were as follows:

 

Name  Age  Position with the Company

William H. Gates III

50Chairman of the Board

Steven A. Ballmer

  5052  Chief Executive Officer

Robert J. (Robbie) Bach

  4446  President, Microsoft Entertainment and Devices Division

Lisa E. Brummel

  4648  Senior Vice President, Human Resources

Stephen A. Elop

44President, Microsoft Business Division

Kevin R. Johnson

  4547  Co-President, MicrosoftPresident, Platforms and Services Division

Christopher P. Liddell

  4850  Senior Vice President and Chief Financial Officer

Robert L. Muglia

48Senior Vice President, Server and Tools

Craig J. Mundie

59Chief Research and Strategy Officer

Raymond E. Ozzie

52Chief Software Architect

Jeffrey S. Raikes

  4850  President, Microsoft Business Division

Bradford L. Smith

  4749  Senior Vice President, Legal and Corporate Affairs;President; General Counsel and Secretary

Brian Kevin Turner

  4143  Chief Operating Officer

Mr. Gates co-founded Microsoft in 1975 and served as its Chief Executive Officer from the time the original partnership was incorporated in 1981 until January 2000, when he resigned as Chief Executive Officer and assumed the position of Chief Software Architect. In June 2006, Mr. Gates stepped down as Chief Software Architect and announced a two-year transition plan out of a day-to-day role in the Company. Mr. Gates has served as Chairman since our incorporation.

Mr. Ballmer was appointed Chief Executive Officer in January 2000. He served as President from July 1998 to February 2001. Previously, he had served as Executive Vice President, Sales and Support since February 1992. He joined Microsoft in 1980.

Mr. Bach was named President, Microsoft Entertainment and Devices Division in September 2005. He had been Senior Vice President, Home and Entertainment since March 2000. Before holding that position, he had been Vice President, Home and Retail since March 1999, and Vice President, Learning, Entertainment and Productivity since 1997, and Vice President, Desktop Applications Marketing since 1996. Mr. Bach joined Microsoft in 1988.

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Ms. Brummel was named Senior Vice President, Human Resources in December 2005. She had been Corporate Vice President, Human Resources since April 2005. From 1995 to April 2005, she had been Corporate Vice President of the Home & Retail Division. Since joining Microsoft in 1989, Ms. Brummel has held a number of management positions, at Microsoft, including general manager of the Consumer Productivity business, product unit manager of the Kids business and product unit manager of Desktopseveral product lines.

Mr. Elop was named President, Microsoft Business Division in January 2008. Prior to joining the Company, Mr. Elop served as Chief Operating Officer of Juniper Networks, Inc. from January 2007 to January 2008. From December 2005 to December 2006, he served as President of Worldwide Field Operations at Adobe Systems Inc. Mr. Elop joined Adobe following the 2005 acquisition of Macromedia Inc., where he was President and Decision reference products.Chief Executive Officer from January 2005 to December 2005. During his almost eight-year tenure at Macromedia, Mr. Elop held many senior positions, including Chief Operating Officer, Executive Vice President of Worldwide Field Operations and General Manager of Macromedia’s eBusiness division.

Mr. Johnson was named Co-President, MicrosoftPresident, Platforms and Services Division in January 2007. He had been Co-President of the Platforms and Services Division since September 2005. He had beenheld the position of Group Vice President, Worldwide Sales, Marketing and Services since March 2003. Before that position, he had been Senior Vice President, Microsoft Americas since February 2002 and Senior Vice President, U.S. Sales, Marketing, and Services since August 2001, and prior2001. Prior to assuming that role, he had been Vice President, U.S. Sales, Marketing and Services. He joined Microsoft in 1992. In July 2008, Mr. Johnson announced his plans to resign from the Company.

Mr. Liddell was named Senior Vice President and Chief Financial Officer of the Company in May 2005. Mr. Liddell served as Senior Vice President and Chief Financial Officer of International Paper Company sincefrom March 2003 through April 2005, and prior to becoming Chief Financial Officer, he held the positions of Vice President-Finance and Controller. Mr. Liddell served as Chief Executive Officer of Carter Holt Harvey Limited, an affiliate of International Paper, from 1999 to 2002 and Chief Financial Officer from 1995 to 1998.

Mr. Muglia was named Senior Vice President, Server and Tools Business in October 2005. Before holding that position, he had a number of leadership positions at Microsoft including Senior Vice President, Enterprise Storage Division since November 2001, Group Vice President, Personal Services Group since August 2000, Group Vice President, Business Productivity since December 1999, Senior Vice President, Business Productivity since March 1999, Senior Vice President, Applications and Tools since February 1998, and Corporate Vice President, Server Applications since 1997. He joined Microsoft in 1988.

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Mr. Mundie was named Chief Research and Strategy Officer in June 2006. He had been Senior Vice President and Chief Technical Officer, Advanced Strategies and Policy since August 2001. He was named Senior Vice President, Consumer Platforms in February 1996. Mr. Mundie joined Microsoft in 1992.

Mr. Ozzie was named Chief Software Architect in June 2006. He had been Chief Technical Officer from April 2005 to June 2006. He assumed that role in April 2005 after Microsoft acquired Groove Networks, a collaboration software company he formed in 1997.

Mr. Raikes was named President, Microsoft Business Division in September 2005. He had been Group Vice President, Information Worker Business since June 2004. Before that position, he had been Group Vice President, Productivity and Business Services since August 2000 and Group Vice President, Sales and Support since July 1998. Mr. Raikes joined Microsoft in 1981. In January 2008, he announced his plans to retire at the end of August 2008.

Mr. Smith was appointednamed Senior Vice President, Legal and Corporate Affairs, General Counsel, and Secretary in November 2001. Mr. Smith was also named Chief Compliance Officer effective July 2002. He had been Deputy General Counsel for Worldwide Sales and previously was responsible for managing the European Law and Corporate Affairs Group, based in Paris. He joined Microsoft in 1993.

Mr. Turner was appointednamed Chief Operating Officer in September 2005. Before joining Microsoft, he was Executive Vice President of Wal-Mart Stores, Inc. and President and Chief Executive Officer of the Sam’s Club division of Wal-Mart Stores, Inc.division. From September 2001 to August 2002, he served as Executive Vice President and Chief Information Officer of Wal-Mart’s Information Systems Division. From March 2000 to September 2001, he served as its Senior Vice President and Chief Information Officer of the Information Systems Division.

EMPLOYEES

As of June 30, 2006,2008, we employed approximately 71,00091,000 people on a full-time basis, 44,00055,000 in the United States and 27,00036,000 internationally. Of the total, 28,00035,000 were in product research and development, 21,00026,000 in sales and marketing, 13,00017,000 in product support and consulting services, 2,0004,000 in manufacturing and distribution, and 7,0009,000 in general and administration. Our success is highly dependent on our ability to attract and retain qualified employees. None of our employees are subject to collective bargaining agreements.

AVAILABLE INFORMATION

Our Internet address is www.microsoft.com. There we make available, free of charge, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably practicable after we electronically file such material with or furnish it to the Securities and Exchange Commission (“SEC”). Our SEC reports can be accessed through the investor relations section of our Web site. The information found on our Web site is not part of this or any other report we file with or furnish to the SEC.

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 developeddevelop and distributed.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. We believe the license-based software model has had substantial benefits for users of software, allowing them to rely on our expertise and the expertise of other software developers that have powerful incentives to develop innovative software that is useful, reliable, and compatible with other software and hardware. In recent years

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certainCertain “open source” software business models have evolved into a growing challenge to 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 have to bear the full costs of research and development for the software. A prominent exampleSome of open source software is the Linux operating system. Whilethese firms may build upon Microsoft ideas that we believeprovide to them free or at low royalties in connection with our products provide customers with significant advantages in security and productivity, and generally have a lower total cost of ownership than open source software, the popularization of the open source software model continues to pose a significant challenge to our business model, including continuing efforts by proponents of open source software to convince governments worldwide to mandate the use of open source software in their purchase and deployment of software products.interoperability initiatives. To the extent open source software gains increasing market acceptance, sales of our products may decline, we may have to reduce the prices we charge for our products, andsales, revenue and operating margins may consequently decline.

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Another development is the software-as-a-service business model byunder which companies provide content, and software in the form of applications, data, and related services, over the Internet. Providers useInternet in exchange for revenues primarily from advertising or subscription-based revenue models. Recent advancessubscriptions. 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 software-as-a-servicecompeting software plus services strategies. It is uncertain whether these strategies will provebe 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 reduce 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. WhileAlthough we believe the breadth of our businesses and product portfolio offers benefits to our customers that areis a competitive advantage, our competitors that are focused on a narrower product linelines 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. The Internet as a distribution channellow and the non-commercial software model described above have reduced barriers to entry even further.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.products, in some cases on the basis of technical specifications for Microsoft technologies that we make available. In response to competitive factors,competition, we are developing versions of our products with basic 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 against piracy, infringement ofrights.    Protecting our patents by third parties, or declining legal protection for intellectual property.    We defend ourglobal intellectual property rights and combatcombating unlicensed copying and use of software and other intellectual property rights through a variety of techniques. Preventing unauthorized use or infringement of our rights is difficult. Piracy of our products represents a loss of revenue to us. While thispiracy adversely affects U.S. revenue, the impact on revenue from outside the United StatesU.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. Future legal changes could make this even more challenging. 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 or compliance with additional intellectual property obligations impacting the rights of software developers could both 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. Responding toTo resolve these claims we may require us to enter into royalty and licensing agreements on less favorable terms, require us to stop selling or to redesign affected products, or to pay damages or to satisfy indemnification commitments with our customers including contractual provisions under various license arrangements. If we are required to enter into suchcustomers. Such agreements or take such actions, ourmay cause operating margins may decline as a result.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.

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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. WhileAlthough we license certain portions of our source code for various software programsapplication and operating systemssystem 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. The loss of future trade secret protectionThis 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 also increase certainthe security risks described in the next paragraph.

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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. WhileAlthough this is an industry-wideindustry- 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 these critical issues. We focus on security vulnerabilities through:

engineering even more secure products, products;

enhancing security and reliability options and settings when we deliver products, and providing guidance to helpfeatures in our products;

helping our customers make the best use of our products and services to protect against computer viruses and other attacks on their computing environment. In addition, we are working to improveattacks;

improving the deployment of software updates to address security vulnerabilities discovered after our products are released. We are also vulnerabilities;

investing in mitigation technologies that help to secure customers from attacks even when such software updates are not deployed. We advisedeployed; and

providing customers on how to help protect themselves from security threats through the use of our online automated security tools, our published security guidance, and the deployment of 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. WhileAlthough our license agreements typically contain provisions that eliminate or limit our exposure to such liability, there is no assurance these provisions will be held effective under applicable laws and judicial decisions.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 based on allegedto 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 November 2001 and a Final Judgment entered in November 2002. These proceedings imposed regulatoryvarious constraints on our Windows operating system businesses, includingbusinesses. These constraints include limits on certain contracting practices, requiredmandated disclosure of certain software program interfaces limits on Microsoft’s abilityand protocols, and rights for computer manufacturers to ensurelimit the visibility of certain Windows features in new PCs, and required licensing of certain communications protocols. While wePCs. We believe we currently are in full compliance with the Decree and Judgment,these rules. However, if we fail to comply with them, in the future 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 March 2004, the European Commission determined that we mustordered us to create new versions of Windows that do not include certain multimedia technologies many of which are required for certain Web sites, software applications and other aspects of Windows to function properly, and we must provide our competitors with specifications for how to implement certain proprietary Windows communications protocols supported in Windows. Microsoft has appealed both determinationstheir own products. The Commission’s impact on product design may limit our ability to European courts. As a resultinnovate in Windows or other products in the future, diminish the developer appeal of the Commission decision, we have incurredWindows platform, and will (absent a reversal of this ruling) continue to incur duplicativeincrease our product development costs. The Commission ruling obligates Microsoft to make available specifications for certain Windows communications protocol technologies on licensing terms that are closely regulated by the Commission. The availability of these licenses related to protocols and file formats may enable competitors to develop software products that better mimic the functionality of Microsoft’sour own products which could result in a reduction indecreased sales of our products. Pending resolution of Microsoft’s appeal, there will remain uncertainty about the legal principles that govern

PAGE14


 Part I 

Item 1A

product design issues for future releases of Microsoft products in Europe. These uncertainties could cause Microsoft to modify product design and delay release dates for Windows or other products.

In December 2005, the Korean Fair Trade Commission (“KFTC”) completed an investigation of whether including streaming media technology or instant messenger technology in Windows, or including Windows Media Services as an optional component of Windows Server, violates the Korean Fair Trade Law. The KFTC ruled that we had violated the law and issued a remedial order requiring us to offer two versions of Windows PC operating systems, one with Windows Media Player and Instant Messenger removed and another with those functionalities but also including opportunities for OEMs to install competing media player and instant messenger programs. If upheld on appeal, these remedies could adversely affect the utility and competitive position of Windows PC operating systems in the Korean market.

We believe our integrated approach to delivery of product innovation benefits consumers and business. Current or future governmentGovernment regulatory effortsactions and court decisions may hinder or delay our ability to provide thesethe benefits of our software to consumers and businesses, thereby reducing the attractiveness of our products and the revenues that come from them. Moreover, there always remains the risk of new legal action,New actions could be initiated at any time, either by these or other governments or private claimants, including with respect to productsnew versions of Windows or features that haven’t been scrutinized or been the subject of objections in the past.other Microsoft products. The outcome of such legal actions, or steps taken to avoid them, could adversely affect us in a variety of ways, including:

 

We may have to designchoose between withdrawing products from certain geographies to avoid fines or developdesigning and developing alternative versions of those products for specific geographical markets to removecomply with government rulings, which may entail removing functionality that customers want or limit visibility of certain functionality, resulting in reduced customer benefitson which developers rely.

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 Part I 

Item 1A

We may be required to make available licenses to our proprietary technologies on terms that do not reflect their fair market value or additional costs and delays in the release of product lines or specific product versions.do not protect our associated intellectual property.

 

Mandated alternative versions of our software may cause confusion that harms our reputation, including among consumers and with third-party software and Web site developers who rely on the functionality removed from these alternative versions.

Competition authorities may authorize competitors to distribute implementations of Microsoft communications protocols in source code form without proper contractual provisions to protect our intellectual property.

We may have to disclose otherwise confidential and trade secret information concerning the operation of our software that may facilitate the development of competing software.

If not reversed or limited on appeal, theThe rulings described above may be cited as a precedent in other proceedings that seek to limit our ability to continue to improve Windows by adding new functionality in response to consumer demand.competition law proceedings.

Our software and services online offerings are subject to government regulation of the Internet domestically and internationally in many areas, such asincluding 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 cease conductingstop doing the alleged noncompliant activity.

Our business depends largely 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, MSNLive Search, Windows Server, Zune, and Windows Live. Investments in new technology are inherently speculative. Commercial success depends on many factors, including innovativeness, developer support, and effective distribution and marketing. SignificantWe may not achieve significant revenue from new product and service investments may not be achieved 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.

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 Part I 

Item 1A

DeclinesAdverse economic conditions may harm our business.    Inflation, softness in corporate information technology spending, or other changes in economic conditions that affect demand for computer hardware or software could occur.adversely affect our revenue or our investment portfolio. If overall market demand for PCs, servers, and other computing devices declines significantly, or consumer or corporate spending for such products declines, our revenue will be adversely affected. In addition, our revenue wouldmay be unfavorably impacted if customers reduce their purchases of new software products or upgrades to existing products because new product offerings such as Windows Vista and the 2007 Microsoft Office system are not perceived as providing significant new functionality or other value to prospective purchasers. We are making significant investments in Windows Vista and the 2007 Microsoft Office system. If these products are not perceived as offering significant new functionality or value to prospective purchasers, our revenue and operating margins could be adversely affected.

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 thethese claims pending against us may result in significant monetary damages or injunctive relief against us that could adversely affect our ability to conduct our business. WhileAlthough management currently believes that resolving all of these matters, individually or in the aggregate, will not have a material adverse impact on our financial position, or 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. There exists the possibility of aA material adverse impact on our financial position, and the 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 both the United States and numerousmany 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

PAGE15


 Part I 

Item 1A

uncertain. We regularly are regularly 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. Based on theThe results of an audit or litigation could have a material effect on our income tax provision, net incomefinancial position, results of operations, or cash flows in the period or periods for which that determination is made could result.made.

WeOur vertically-integrated hardware and software products may be at risk of having insufficient supplies of certain Xbox 360 componentsexperience quality or console inventory.supply problems    Some components of.    Our hardware products such as the Xbox 360 console are obtainedhighly 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 a single supplier and others may be subject to an industry-wide supply shortage.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, on a timely basis, resulting in reduced console and game sales. Components are ordered based on forecasted console demand so we may experienceEither component shortages for the Xbox 360 or alternatively, excess consoleor obsolete inventory that may require us to record charges to cost of revenue. Xbox 360 consoles will beare 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 required to be 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 to earnings 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.

Changes in accounting may affect our reported earnings and operating income.    Generally accepted accounting principles and accompanying accounting pronouncements, implementation guidelines, and interpretations for many aspects of our business, such as revenue recognition for software, accounting for investments, and treatment of goodwill or amortizable intangible assets, are highly complex and involve subjective judgments. Changes in these rules or their interpretation or changes in our products or business could significantly change our reported earnings and operating income and could add significant volatility to those measures, without a comparable underlying change in cash flow from operations. See Note 1 in “Item 8. Financial Statements and Supplementary Data” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies” of this report.

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

PAGE16


 Part I 

Item 1A

require that we reduce the sales price of our software in the United States and other countries. Operations outside of the United States may be affected by changes in trade protection laws, policies and measures, and other regulatory requirements affecting trade and investment; unexpected 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. WhileAlthough 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.

General economic and geo-political risks may affect our revenue and profitability.    Inflation, softness in corporate information technology spending, or other changes in general economic conditions that affect demand for computer hardware or software could adversely affect our revenue or our investment portfolio. Abrupt political change, terrorist activity, and armed conflict pose a risk of general economic disruption in affected countries or generally and could require changes in our operations and security arrangements, thus increasing our operating costs. These conditions may lend additional uncertainty to the timing and budget for technology investment decisions by our customers.

Catastrophic events or geo-political conditions may disrupt our business.    We are a highly automated business and aA 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, and providing services.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 severely affectharm our ability to conduct normal business operations and asour operating results. Abrupt political change, terrorist activity, and armed conflict pose a result,risk of general economic disruption in affected countries, which may increase our future operating results could be adversely affected.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 theour investment, we make, or that we may experience difficulty in the integration of new employees, business systems, and technology, or diversion of management’s attention from our other businesses. These factorsevents could adversely affectharm our operating results or financial condition.

PAGE16


We have limited insurance.    We maintain third party insurance coverage against various liability risks and risks of property loss. Because of the unavailability or high cost of conventional insurance arrangements, we have entered into captive insurance arrangements for the purpose of protecting against possible catastrophic and other risks not covered by traditional insurance markets. As of June 30, 2006, the face value of captive insurance arrangements was $2.0 billion. Actual value at any particular time will vary due to deductibles, exclusions, other restrictions, and claims. While we believe these arrangements are an effective way to insure against liability and property damage risks, the potential liabilities associated with the risks discussed in this report or other events could exceed the coverage provided by such arrangements. Part I 

Item 1A, 1B, 2

Improper disclosure of personal data could result in liability and harm our reputation.    We store and process significantlarge amounts of personally identifiable information as we offer a large array of products and services to our customers.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:

include sales channel disruption, such as the bankruptcy of a major distributor;

distributor, and our ability to implement operating cost structures that align with revenue growth;

the continued availability of third-party distribution channels for MSN service and other online offerings; and

disruption to our operations as a result of weather-related events.

PAGE17


 Part I growth.

Item 1B, 2, 3, 4

ITEM 1B.    UNRESOLVED STAFF COMMENTS

We have received no written comments regarding our periodic or current reports from the staff of the SEC that were issued 180 days or more preceding the end of our fiscal year 20062008 that remain unresolved.

ITEM 2.    PROPERTIES

Our corporate offices consist of approximately 11.013 million square feet of office building space located in King County, Washington: 8.5nine million square feet of owned space that is situated on approximately 500 acres of land we own inat our corporate campus in Redmond, Washington and approximately 2.5four million square feet of space we lease. We own approximately 533,000two million square feet of office building space domestically (outside of the Puget Sound corporate campus) and lease many sites domestically totaling approximately 2.7four million square feet of office building space.

We occupy many sites internationally, totaling approximately 6.9two million square feet that is leasedowned and approximately 883,000eight million square feet that is owned. These facilitiesleased. Facilities that we own include our European Operations Center that leases a 187,000 square foot campus in Dublin, Ireland,Ireland; the India Development Center in Hyderabad, India; and a 56,000 square footfacility in Reading, UK. The largest leased office spaces include the following locations: Beijing and Shanghai, China; Bangalore, India; Dublin, Ireland; Tokyo, Japan; Mississauga, Canada; Taipei, Taiwan; Seoul, Korea; Sydney, Australia; and Milan, Italy. In addition to the above locations, we have a disk duplication and digital distribution facility in Humacao, Puerto Rico, and a 159,000 square foot facility in Singapore for our Asia Pacific Operations Center and Regional headquarters. Leased office building space includes the following locations: Tokyo, Japan 408,000 square feet; Unterschleissheim, Germany 381,000 square feet; Les Ulis, France 262,000 square feet; Reading, England 241,000 square feet;headquarters, and Mississauga, Canada 161,000 square feet. In addition to the above locations, we have various product development facilities, both domestically and internationally, as described in “Operations”the “Product Development” section above.

Our facilities are fully used for current operations of all segments, and suitable additional space isspaces are available to accommodate expansion needs. We own 63 acres of land in Issaquah, Washington, which can accommodate 1.2 million square feet of office space and we have ana development agreement with the City of Redmond under which we may currently develop anapproximately 850,000 square feet of additional 2.2facilities at our corporate campus in Redmond, Washington. In addition, we own 63 acres of undeveloped land in Issaquah, Washington, that can accommodate approximately one million square feet of facilities at our campus in Redmond, Washington.office space.

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 Part I 

Item 3, 4

ITEM 3.    LEGAL PROCEEDINGS

On May 22, 2006, the Korean Fair Trade Commission (“KFTC”) denied our motion for reconsideration of the formal written ruling against us in its competition law investigation of the company. As part of its decision, however, the KFTC dropped the requirement prohibiting us from including Windows Media Player or Windows Messenger, or any feature with similar functionality, in any product other than the Windows client operating system for which we have a 50% or greater market share. Our request to stay the KFTC corrective order was denied on July 31, 2006. Our appeal of the KFTC’s decision to the Seoul High Court is still pending.

On July 12, 2006,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 its determinationon October 22, 2007 that we had not compliedwere in compliance with the technical documentation requirements in itsMarch 2004 Decision against us,decision and leviedthat no further penalty should be imposed from that date. In February 2008, the Commission issued a fine of $1.4 billion (281 million ($351899 million). We intend to appeal this fine related to the period prior to October 22, 2007. In May 2008, we filed an application with the European Court of First Instance. We have completedInstance to annul the written and oral procedures in our appeal of the Commission’s underlying March 2004 decision finding Microsoft in violation of European competition law and accompanying497 million ($605 million) fine and are awaiting a decision by the Court of First Instance.fine.

See Note 1715 – Contingencies in “Item 8.of the Notes to Financial Statements and Supplementary Data”(Part II, Item 8) for information regarding otherabout legal proceedings in which we are involved.

ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security holders during the fourth quarter of fiscal year 2006.2008.

 

PAGE 18


 Part II 

Item 5

 

PART II

ITEM 5.    MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock is traded on The NASDAQ Stock Market under the symbol MSFT. On August 18, 2006,July 28, 2008, there were 148,993145,903 registered holders of record of our common stock. The high and low common stock sales prices per share were as follows:

 

Quarter Ended  Sep. 30  Dec. 31  Mar. 31  June 30  Year  Sep. 30  Dec. 31  Mar. 31  June 30  Year

Fiscal year 2005

          

Fiscal year 2008

          

Common stock price per share:

                    

High

  $29.00  $29.98  $26.84  $26.07  $29.98  $31.84  $37.50  $35.96  $32.10  $37.50

Low

   26.88   26.53   23.92   24.12   23.92   27.51   29.29   26.87   27.11   26.87

Fiscal year 2006

          

Fiscal year 2007

          

Common stock price per share:

                    

High

  $27.76  $28.16  $28.15  $27.74  $28.16  $27.52  $30.26  $31.48  $31.16  $31.48

Low

   24.65   24.30   26.28   21.51   21.51   22.23   27.15   26.60   27.56   22.23

See Note 1216 – Stockholders’ Equity of the Notes to Financial Statements (Item(Part II, Item 8) for information regarding dividends approved by our Board of Directors in fiscal years 20062008 and 2005.2007.

On July 20, 2006, we announced the completion of the repurchase program approved by our Board of Directors on July 20, 2004, to buy back up to $30 billion in Microsoft common stock. The repurchases were made using our cash resources. We repurchased common stock in each quarter of fiscal year 2006 as follows:

Period  Total number of
shares purchased
  Average price
paid per share

July 1, 2005 – September 30, 2005

  114,134,218  $26.54

October 1, 2005 – December 31, 2005

  283,112,246  $27.08

January 1, 2006 – March 31, 2006

  180,720,830  $27.00

April 1, 2006 – June 30, 2006

  175,609,060  $23.78

Common stock repurchases in the fourth quarter of fiscal year 2006 were as follows:

Period  (a) Total number of
shares purchased
  (b) Average
price paid per
share
  (c) Total number of
shares purchased as
part of publicly
announced plans or
programs
  (d) Maximum number of shares
(or approximate dollar value)
of shares that may yet be
purchased under the plans or
programs (in millions)

April 1, 2006 – April 30, 2006

  38,041,415  $27.08  38,041,415  $5,394

May 1, 2006 – May 31, 2006

  8,618,036  $24.37  8,618,036  $5,184

June 1, 2006 – June 30, 2006

  128,949,609  $22.76  128,949,609  $2,249
        
  175,609,060    175,609,060  
          

On July 20, 2006, we announced that our Board of Directors authorized two new share repurchase programs: a $20$20.0 billion tender offer which was completed on August 17, 2006; and authorization for up to an additional $20$20.0 billion ongoing share repurchase program with an expiration ofthat expires on June 30, 2011. Under the tender offer, we repurchased approximately 155 million shares of common stock, or 1.5% of our common shares outstanding, for approximately $3.8 billion at a price per share of $24.75.

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 Part II 

Item 5, 6

On August 18, 2006, we announced that the authorization for the $20.0 billion ongoing share repurchase program previously announced on July 20, 2006, had been increased by approximately $16.2 billion. As a result, the company iswe were authorized to repurchase additional shares in an amount up to $36.2 billion through June 30, 2011. The repurchase program may be suspended or discontinued at any time without prior notice. The transactions occurred in open market purchases and pursuant to a trading plan under Rule 10b5-1. We repurchased common stock in each quarter of fiscal year 2008 using available cash resources as follows:

Period  Total number of
shares purchased
  Average price
paid per share

July 1, 2007 – September 30, 2007

  80,597,986  $29.14

October 1, 2007 – December 31, 2007

  119,614,762  $34.12

January 1, 2008 – March 31, 2008

  30,160,464  $33.82

April 1, 2008 – June 30, 2008

  171,474,350  $29.01
   

Total share repurchases in fiscal year 2008

  401,847,562  
     

Common stock repurchases in the fourth quarter of fiscal year 2008 were as follows:

Period  (a) Total number
of shares
purchased
  (b) Average
price paid per
share
  (c) Total number of
shares purchased as
part of publicly
announced plans or
programs
  (d) Approximate dollar
value of shares that
may yet be purchased
under the plans or
programs (in millions)

April 1, 2008 – April 30, 2008

    $    $7,688

May 1, 2008 – May 31, 2008

  82,151,000  $29.77  82,151,000  $5,243

June 1, 2008 – June 30, 2008

  89,323,350  $28.31  89,323,350  $2,714
        
  171,474,350    171,474,350  
          

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 Part II 

Item 6

ITEM 6.    SELECTED FINANCIAL DATA

FINANCIAL HIGHLIGHTS

 

(In millions, except per share data)                                        
Fiscal Year Ended June 30  2006  2005  2004  2003  2002
Fiscal Year Ended June 30,  2008  2007  2006  2005  2004

Revenue

  $44,282  $39,788  $36,835  $32,187  $28,365  $60,420  $51,122  $44,282  $39,788  $36,835

Operating income

   16,472   14,561   9,034   9,545   8,272  $22,492  $18,524  $16,472  $14,561  $9,034

Net income

   12,599   12,254   8,168   7,531   5,355  $17,681  $14,065  $12,599  $12,254  $8,168

Diluted earnings per share

  $1.20  $1.12  $0.75  $0.69  $0.48  $1.87  $1.42  $1.20  $1.12  $0.75

Cash dividends declared per share

  $0.35  $3.40  $0.16  $0.08  $  $0.44  $0.40  $0.35  $3.40  $0.16

Cash and short-term investments

   34,161   37,751   60,592   49,048   38,652

Cash, cash equivalents, and short-term investments

  $23,662  $23,411  $34,161  $37,751  $60,592

Total assets

   69,597   70,815   94,368   81,732   69,910  $72,793  $63,171  $69,597  $70,815  $94,368

Long-term obligations

   7,051   5,823   4,574   2,846   2,722  $6,621  $8,320  $7,051  $5,823  $4,574

Stockholders’ equity

   40,104   48,115   74,825   64,912   54,842  $36,286  $31,097  $40,104  $48,115  $74,825

 

PAGE 20


 Part II 

Item 7

ITEM 7.     MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

RESULTS OF OPERATIONS FOR FISCAL YEARS 2006, 2005,2008, 2007, AND 20042006

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 develop, manufacture, license,generate revenue by developing, manufacturing, licensing, and supportsupporting a wide range of software products and services for many different types of computing devices. Our software products and services include operating systems for servers, PCs,personal computers, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutions applications; andhigh-performance computing applications; software development tools.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 games, PC games,entertainment device, and PC peripherals. Online communicationofferings and information services are delivered through Live Search, Windows Live, Office Live, our MSN portals and channels, aroundand the world.Microsoft Online Services platform which includes offerings for businesses such as Microsoft Dynamics CRM Online, Exchange Hosted Services, Exchange Online, and SharePoint Online. We enable the delivery of online advertising across our broad range of digital media properties and on Live Search through our proprietary adCenter® platform.

Our revenue historically has fluctuated quarterly and has generally been the highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers. Our HomeEntertainment and Entertainment segmentDevices Division is particularly subject to seasonalityseasonal as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Typically, Homethe Entertainment and EntertainmentDevices Division has generated over 40% of its yearly segment revenues in our second fiscal quarter. We believeIn fiscal year 2007, our revenue was highest in the seasonalitythird quarter due to the recognition of $1.7 billion of revenue is likelypreviously deferred from the Express Upgrade to continue inWindows Vista and Microsoft Office Technology Guarantee programs and pre-shipments of Windows Vista and the future.2007 Microsoft Office system. The technology guarantee programs provided customers who purchased current products with free or discounted rights to Windows Vista and the 2007 Microsoft Office system when those products became available to consumers.

We intend to sustain the long-term growth of our businesses through technological innovation, engineering excellence, and a commitment to delivering high-quality products and services to customers and partners. Recognizing that one of our primary challenges is to help accelerate worldwide PC adoption and software upgrades, we continue to advance the functionality, security, and value of Windows operating systems.systems and to develop operating system versions targeted at emerging markets. We also are increasing our focus on selling our products in emerging markets and reducing the amount of unlicensed software used in those markets. In addition, we continue to develop innovative software applications and solutions that we believe will enhance the productivity of information workers, improve communication and collaboration in work groups, aid business intelligence, and streamline processes for small and mid-sized businesses. To sustain the growth of our Server and Tools business amid competition from other vendors of both proprietary and open source software, our goal is to deliver products that provide the best platform for network computing – thesoftware that is easiest to deploy and manage, and that is most secure – with the lowest total cost of ownership.

We continue to invest in research and development in existing and new lines of business, including online solutions, business solutions, mobile computing, communication, entertainment, and othersother areas that we believe may contribute to our long-term growth. We also invest in research and developdevelopment of advanced technologies for future software products. We believe that delivering innovative and high-value solutions through our integrated platform is the key to meeting customer needs and to our future growth.

We believe that over the last few years we have laid a foundation for long-term growth by delivering innovative products, creating opportunities for partners, improving customer satisfaction with key audiences, putting some of our most significant legal cases behind us, and improving our internal business processes. Our focus in fiscal year 20072009 is buildingto continue to build on this foundation and executingto continue to execute well in key areas, including continuing to innovate on our integrated software platform, responding effectively to customer and partner needs, and continuing to focus internally on product excellence, business efficacy, and accountability across the company.

Key market opportunities include:

Strengthening core businesses through new product launches, upgrades, making inroads against software piracy, and extending PC accessibility to new consumers in emerging markets.

Succeeding in adjacent businesses by offering extensions of our technologies targeted towards specific customer needs – either as new products or as higher-value versions of existing products.

Entering new markets as we redefine how people create, deliver, and experience entertainment.

Delivering software services through online consumer services and services for businesses that enable workers to collaborate interactively.

 

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Worldwide macroeconomic factors have

Key market opportunities include:

Consumer technology.    We are focused on delivering consumer software products that we believe are compelling in terms of design, features, and functionality. We also are working to define the next era of consumer electronics through the development of innovative software that runs on a strong correlationwide range of devices and connects people quickly and easily to businessthe information, experiences, and consumer demand forcommunities they care about.

Software plus services.    The ability to combine the power of desktop and server software with the reach of the Internet represents an opportunity across every one of our businesses. We believe our software plus services gamesapproach will enable us to deliver new experiences to end users and Internet service offerings. We expect a broad continuationnew value to businesses.

Expanding our presence on the desktop, the server, and with developers.    Through our ability to deliver additional value in security, messaging, systems management, and collaboration, and new technology for high-performance computing, unified communications, and business intelligence, we believe we are well-positioned to build on our strength with businesses of all sizes and with developers. Fiscal year 2008 saw widespread adoption of Windows Vista and the economic conditions2007 Microsoft Office system and demand in fiscal year 2007 as compared to fiscal year 2006.

As open source software developmentthe launch of Windows Server 2008, SQL Server 2008, and distribution evolves, we continue to seek to differentiate our products from competing products that are based on open source software. We believe that Microsoft’s share of server unit operating systems increased in fiscal year 2006.Visual Studio 2008.

Summary of Results for Fiscal Years 2006, 2005,2008, 2007, and 20042006

 

(In millions, except percentages)  2006  2005  2004  

Percent
Change 2006

versus 2005

  

Percent
Change 2005

versus 2004

  2008  2007  2006  

Percentage
Change 2008

versus 2007

  

Percentage
Change 2007

versus 2006

Revenue

  $44,282  $39,788  $36,835  11%  8%  $60,420  $51,122  $44,282  18%  15%

Operating income

  $16,472  $14,561  $9,034  13%  61%  $22,492  $18,524  $16,472  21%  12%

Diluted earnings per share

  $1.87  $1.42  $1.20  32%  18%

Our revenue growth forFiscal year 2008 compared with fiscal year 20062007

Revenue growth was driven primarily by growth in SQL Server followingincreased licensing of the launch of SQL Server 2005 in the second quarter,2007 Microsoft Office system, increased Xbox 360 platform sales, increased revenue associated with Windows Server and other server applications, increased Xbox revenue resulting from the Xbox 360 launch in the second quarter, growth in licensing of Windows client operating systems through OEMs,SQL Server, and increased licensing of OfficeWindows Vista. Foreign currency exchange rates accounted for a $1.6 billion or three percentage point increase in revenue during the year.

Operating income increased primarily reflecting increased revenue, partially offset by increased headcount-related expenses, increased costs for legal settlements and other Information Worker products. Based onlegal contingencies, and increased cost of revenue. Headcount-related expenses increased 12%, reflecting an increase in headcount during the year. We incurred $1.8 billion of legal charges during the year primarily related to the European Commission fine of $1.4 billion (899 million) as compared with $511 million of legal charges during the prior year. Cost of revenue increased $905 million or 8%, reflecting increased data center and equipment costs, online content expenses, and increased costs associated with the growth in our estimates, total worldwide PC shipments from all sources grew approximately 12% to 14% and total server hardware shipments grew approximately 11% to 13% duringconsulting services, partially offset by decreased Xbox 360 costs. The decreased Xbox 360 costs reflect the $1.1 billion charge in fiscal year 2006.2007 related to the expansion of our Xbox 360 warranty coverage as discussed below, partially offset by increased Xbox 360 product costs reflecting growth in unit console sales.

The diluted earnings per share growth was impacted by the $1.1 billion Xbox 360 charge in fiscal year 2007 and current year share repurchases.

Fiscal year 2007 compared with fiscal year 2006

Revenue growth was driven primarily by licensing of the 2007 Microsoft Office system and Windows Vista, increased revenue associated with SQL Server, Windows Server, and Visual Studio, and increased Xbox 360 platform sales. Foreign currency exchange rates did not have a significant impact on consolidated or operating segment revenue during the fiscal year.

Revenue growth for fiscal year 2005 was driven by growth in licensing of Windows Server operating systems and other server applications, licensing of Windows client operating systems through OEMs, and increased licensing of Office and other Information Worker products. The November 2004 launch of the “Halo 2” Xbox game also contributed to overall revenue growth for the company. Total worldwide PC shipments from all sources grew approximately 11% to 13% and total server hardware shipments grew approximately 13% to 14% during fiscal year 2005 as compared to fiscal year 2004. The net impact of foreign exchange rates on revenue was positive in 2005, primarily due to relative strengthening of most foreign currencies, particularly the euro and Japanese yen, against the U.S. dollar. Partially offsetting revenue growth rates was a $1.08 billion decline in earned revenue from Upgrade Advantage in fiscal year 2005. This revenue was recognized over fiscal year 2003 and fiscal year 2004 and in the first quarter of fiscal year 2005 when the contract period expired. Fiscal year 2004 revenue growth was primarily driven by the growth in licensing of Windows client operating systems through OEMs, Windows Server operating systems, Office and other server applications as a result of growth in PC and server hardware shipments. The worldwide PC shipment growth rate from all sources was estimated at 13% and the Windows server shipment was estimated at 18% in fiscal year 2004 as compared to fiscal year 2003. The net impact of foreign exchange rates on revenue was positive in fiscal year 2004 due to a relative strengthening of most foreign currencies versus the U.S. dollar. This resulted in approximately $1.10 billion growth in total revenue.

Operating income for fiscal year 2006growth was driven primarily by increased primarily reflecting the revenue increase and a $991 million decrease indecreased costs for legal settlements and legal contingencies. These changes werecontingencies, partially offset by a $1.62 billion increase inincreased cost of revenue primarily related toassociated with Xbox 360 and Windows Vista, increased OSB data centers costs, and increased sales and marketing expenses. In July 2007, we expanded our global Xbox 360 warranty coverage to three years from the date of purchase for a $1.26general hardware failure indicated by three flashing red lights. As a result, we recorded a $1.1 billion charge in fiscal year 2007 for anticipated costs under the warranty policy, inventory write-downs, and product returns. The increase in sales and marketing expense primarily as a result of increased investments in partner marketing and product launch-related spending. Headcount-related costs, including stock-based compensation expense, increased $682 million or 7% resulting from both an increase in salaries and benefits for existing headcount and a 16% growth in headcount over the past twelve months. Stock-based compensation expense decreased $733 million or 30% reflecting a continuing decline in stock option amortization expense.expenses

Operating income increased in fiscal year 2005 due to a decline in stock-based compensation expense; increased revenue in Server and Tools, Client and Information Worker, which have higher gross margins as compared to other segments; and a reduction in legal costs associated with major litigation. In addition, strong sales of Halo 2 reduced the overall operating loss for the Home and Entertainment segment for fiscal year 2005. The $3.29 billion decrease in stock-based compensation expense was partially offset by increased operating expenses of $562 million related to increased salary and benefits for new and existing headcount. General and administrative expenses related to major litigation declined in fiscal year 2005 due to the $2.53 billion of charges related to the settlement of Sun

 

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Microsystems litigation

was primarily driven by increased headcount-related expenses and the fine imposed by the European Commission in fiscal year 2004. This effect was partially offset by legal expenses of $2.08 billionmarketing costs related to settlements with IBM, Novell, Gateway, and end-user class action plaintiffs to resolve antitrust issues and other matters. In fiscal year 2004, the operating income decline was caused primarily by $2.53 billion of legal charges and $2.21 billion of stock-based compensation expense related to our employee stock option transfer program, mainly offsetproduct launches. Headcount-related expenses increased 18%, driven by an increase in revenue.headcount during the year.

We implemented changes in employee compensation inFiscal Year 2009 Outlook

Global macroeconomic factors have a strong correlation to demand for our software, services, hardware, and online offerings. In fiscal year 2004 whereby employees are granted stock awards rather than stock options. We also completed an employee stock option transfer program in2009, we expect a broad continuation of the second quartereconomic conditions and demand we experienced during the latter part of fiscal year 2004 in which employees could elect to transfer all of their vested and unvested stock options with a strike price of $33.00 or higher to JPMorgan Chase Bank (“JPMorgan”). The unvested options that were transferred to JPMorgan became vested upon the transfer. A total of 345 million of the 621 million eligible options were transferred, which resulted in additional stock-based compensation expense of $2.21 billion in the second quarter of fiscal year 2004. As a result of these changes, stock-based compensation expense decreased in fiscal years 2006 and 2005, and we expect stock-based compensation expense related to stock options to continue to decrease in fiscal year 2007.

Fiscal Year 2007 Outlook

2008. In fiscal year 2007,2009, we expect continued double digit revenue growth primarily as a result of the upcoming launches of Windows Vista and the 2007 Microsoft Office system. Wewe estimate worldwide PC shipments will grow between 8%12% and 10%14%. WeWithin the overall PC market, we expect that PC unit growth rates will be higher in thecurrent trends to continue with consumer segment than ingrowth exceeding that of the business segment and higher in emerging markets than inmarket growth exceeding that of mature markets. We estimate worldwide server unit shipments will grow between 10% and 12% in fiscal year 2007 as compared to fiscal year 2006. We do not expect a significant impact from year-over-year foreign currency exchange rates in fiscal year 2007.

We expect our operating income growth rate to lag our revenue growth rate in the first half of fiscal year 2007 due to an increasing mix of Xbox 360 console revenue and related costs, coupled with significant investments in preparation for the launches of our flagship products. We expect this trend to reverse in the second half of the fiscal year when we expect operating income to grow faster than revenue.

SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS)

Our seven segments were Client; Server and Tools; Information Worker; Microsoft Business Solutions; MSN; Mobile and Embedded Devices; and Home and Entertainment. On July 17, 2006, we announced a change in our operating segments reflecting the culmination of our realignment announced in September 2005. These changes will be effective for fiscal year 2007; the seven segments discussed in this analysis are presented the way we internally managed and monitored performance at the business group level in fiscal years 2006, 2005, and 2004.

The revenue and operating income/income (loss) amounts in this section are presented on a basis consistent with U.S. Generally Accepted Accounting Principles (“GAAP”) and include certain reconciling items attributable to each of the segments. The segment information appearing in Note 1819 – Segment Information of the Notes to Financial Statements (Part II, Item 8) is presented on a basis consistent with the Company’s internal management reporting, in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 131,Disclosures about Segments of an Enterprise and Related Information. Certain corporate level expenses havecorporate-level activity has been excluded from our segment operating results and are analyzedis presented separately. Fiscal years 2005 and 2004Prior period amounts have been restated for certain internal reorganizations andrecast to conform to the fiscal year 2006 presentation.way we internally manage and monitor performance at the segment level during the current period.

Client

 

(In millions, except percentages)  2006  2005  2004  

Percent
Change 2006

versus 2005

  

Percent
Change 2005

versus 2004

Revenue

  $13,209  $12,151  $11,556  9%  5%

Operating income

  $10,203  $9,464  $8,740  8%  8%

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(In millions, except percentages)  2008  2007  2006  

Percentage
Change 2008

versus 2007

  

Percentage
Change 2007

versus 2006

Revenue

  $16,865  $14,976  $13,107  13%  14%

Operating income

  $13,052  $11,467  $10,208  14%  12%

Client consistsofferings consist of premium and standard edition Windows operating systems, includingsystems. 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,Edition. Standard editions include Windows Vista Home Basic and other standard Windows operating systems, including Windows XP Home. Premium offerings are Windows operating systems sold at a premium above Windows XP Home. Client revenue growth generally correlates with the growth of PC purchases of PCs from OEMs that pre-install versions of Windows operating systems because the OEM channel accounts for over 80% of total Client revenue.

Client The differences between unit growth rates and revenue increasedgrowth rates from year to year are affected by changes in fiscal year 2006 reflecting $1.18 billion or 12% growth in OEM revenue driven by 17% growth in OEM license units from increased PC unit shipments, partially offset by a $118 million or 6% decrease in revenue from commercial and retail licensing of Windows operating systems. During the year, the mix of OEM Windows operating systems licensed with premium edition operating systems as a percentage of total OEM Windows operating systems licensed (“OEM Premium Mix”premium mix”) increased two percentage points to 52%. OEM revenue growth included an increase to revenue of $89 million resulting from the alignment of our billings associated with OEM distributors in our system builder channel with both industry standards and other Microsoft channels. The differences between unit growth rates and revenue growth rates from year to year are affected by changes in the OEM Premium Mix,, changes in the geographical mix, and changes in the channel mix of products sold by large, multi-national OEMs versus those sold by local and regional system builders.

Fiscal year 2008 compared with fiscal year 2007

Client revenue increased reflecting growth in licensing of Windows Vista. By the end of fiscal year 20052008, more than 180 million Windows Vista licenses had been sold (approximately 130 million were sold during fiscal year 2008) and millions of enterprise seats had been deployed. OEM revenue increased $1.7 billion or 13%, driven by 16% growth in OEM license units. Revenue from commercial and retail licensing of Windows operating systems increased $209 million or 8%, primarily from Enterprise Agreements and anti-piracy efforts in emerging markets. During the year, the OEM premium mix increased seven percentage points to 74%, reflecting strong demand for Windows Vista Home Premium. Based on our estimates, total worldwide PC shipments from all sources grew approximately 12% to 14%, driven by demand in both emerging and mature markets.

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Client operating income increased reflecting increased revenue, partially offset by increased sales and marketing expenses and cost of revenue. Sales and marketing expenses increased $149 million or 10%, primarily reflecting increased expenses associated with our corporate sales force. Cost of revenue increased $115 million or 13%, primarily driven by Windows Vista product costs.

Fiscal year 2007 compared with fiscal year 2006

Client revenue increased primarily reflecting licensing of Windows Vista. OEM revenue increased $1.4 billion or 13% driven by 13% growth in OEM license units and $886 million or 10% growth in OEM revenue from increased PC unit shipments, partially offset by a $198 million or 9% decrease inwhile revenue from commercial and retail licensing of Windows operating systems. Thesystems increased $447 million or 22%. During the year, the OEM Premium Mix remained flat at 50% ofpremium mix increased 15 percentage points to 67%. We estimate total OEM Windows operating systems as comparedworldwide PC shipments from all sources grew 10% to the previous year. Revenue earned from Upgrade Advantage declined12% driven by $99 milliondemand in fiscal year 2005 contributing to the decrease in commercialboth emerging and retail licensing revenue.mature markets.

Client operating income increased in fiscal year 2006 reflecting the increase in OEMincreased revenue and decreased research and development costs, partially offset by a $224 million increase inincreased Windows Vista product costs and sales and marketing expenses excluding headcount-related costs, mainly driven by increased investmentsfor launch-related programs. The decrease in partner marketingresearch and development expenses reflected the capitalization of certain Windows Vista pre-launch programs.software development costs and completion of product development on Windows Vista. Headcount-related costs increased 6% in fiscal year 2006 reflecting both a 13% increase in headcountexpenses decreased 7%, primarily associated with Windows Vista and further investments in our sales and marketing organization, and an increase in salaries and benefits for existing headcount, partially offsetdriven by a decrease in stock-based compensation expense.headcount during the year.

Fiscal Year 2009 Outlook

We expect PC market growth will exceed Client operating income increasedrevenue growth. We believe PC unit growth rates will be higher in fiscal year 2005 primarily due to an increasethe consumer segment than in OEM revenuethe business segment and a $444 million decreasehigher in stock-based compensation expense. These factors were partially offset by an increaseemerging markets than in sales and marketing expenses associated with “Start Something,” a globally launched advertising campaign, marketing for security initiatives, and an increase in salary and benefits for new and existing headcount. The additional headcount for research and development was primarily devoted to the continued development of Windows Vista.mature markets.

Server and Tools

 

(In millions, except percentages)  2006  2005  2004  

Percent
Change 2006

versus 2005

  

Percent
Change 2005

versus 2004

  2008  2007  2006  

Percentage
Change 2008

versus 2007

  

Percentage
Change 2007

versus 2006

Revenue

  $11,467  $9,938  $8,590  15%  16%  $13,170  $11,171  $9,665  18%  16%

Operating income

  $4,323  $3,291  $1,474  31%  123%  $4,593  $3,643  $2,868  26%  27%

Server and Tools consists of server software licenses and client access licenses (“CAL”) for Windows Server, Microsoft SQL Server, Exchange Server and other server products. It also includes developer tools, training, certification, Microsoft Press, Premier and Professional product support services, and Microsoft Consulting Services. Server and Tools concentrates on licensing products, applications, tools, content, and services that make information technology professionals and developers more productive and efficient. The segment usesServer 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. TheWe sell licenses are sold both as one-time licenses and as multi-year volume licenses. Server and Tools uses product innovation and partnerships

Fiscal year 2008 compared with information technology professionals to drive the adoption and sales growth of its products.fiscal year 2007

Server and Tools revenue increased during fiscal year 2006 mainlyreflecting growth in product and services revenue and included a favorable impact from foreign currency exchange rates of $464 million or four percentage points. Server and server application revenue (including CAL revenue) and developer tools revenue increased $1.4 billion or 15%, primarily driven by growth in SQL Server,volume licensing of Windows Server and Core CAL. SQL Server 2005products. This growth reflects broad adoption of the Windows Platform and applications with the releases of Windows Server 2008 and Visual Studio 2005 were launched2008 during the fiscal year. Consulting and Premier and Professional product support services revenue increased $593 million or 29%, primarily due to higher demand for consulting and support services by corporate enterprises.

Server and Tools operating income increased primarily due to growth in high-margin product revenue, partially offset by increased sales and marketing expenses, cost of revenue, and research and development expenses. Sales and marketing expenses increased $475 million or 14%, due to higher expenses associated with our corporate sales force. Cost of revenue increased $394 million or 18%, reflecting the second quarter ofgrowth in Consulting and Premier and

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Professional product support services. Research and development expenses increased $183 million or 11%, primarily driven by increased headcount-related expenses. Headcount-related expenses increased 8%, driven by an increase in headcount during the year.

Fiscal year 2007 compared with fiscal year 2006 and produced revenue growth in these product lines. Revenue is impacted by overall server hardware shipments which we estimate grew 11% to 13% in fiscal year 2006.

Server and Server applicationsserver application revenue including(including CAL revenue,revenue) and developer tools, training, and certification revenue grew $1.31increased $1.1 billion or 16% during fiscal year 2006.13%, and included a favorable impact from foreign currency exchange rates of $168 million or two percentage points. The increase in server and server application revenue was primarily driven by increased revenue associated with SQL Server, Windows Server, and Visual Studio. The results reflect broad adoption of Windows Server products, especially SQL Server which grew over 30%20%. Consulting and Premier and Professional product support services revenue increased $428 million or 26%, primarily due to higher demand for Premier services by corporate enterprises.

Server and Tools operating income increased reflecting the increased revenue, partially offset by growth in headcount-related expenses and cost of revenue for services. Headcount-related expenses increased 14%, driven by an increase in headcount during the year. Cost of revenue increased $260 million or 14%, reflecting growth in Consulting and Premier and Professional product support services.

Fiscal Year 2009 Outlook

We expect continued growth in both product and services revenue driven by strong customer demand for the recently released Windows Server 2008 and Visual Studio 2008 and upcoming release of SQL Server 2008.

Online Services Business

 

(In millions, except percentages)  2008  2007  2006  

Percentage
Change 2008

versus 2007

  

Percentage
Change 2007

versus 2006

 

Revenue

  $3,214  $2,441  $2,296  32% 6%

Operating income (loss)

  $(1,233) $(617) $5  (100)% * 
*

Not meaningful

Online Services Business (“OSB”) consists of an on-line advertising platform with offerings for both publishers and advertisers, personal communications services such as email and instant messaging, online information offerings such as Live Search, and the MSN portals and channels around the world. We earn revenue primarily from online advertising, including search, display, and email and messaging services. Revenue is also generated through subscriptions and transactions generated from online paid services, from advertiser and publisher tools, digital marketing and advertising agency services, and from MSN narrowband Internet access subscribers. We continue to launch new online offerings and expect to do so in the future. During fiscal year 2008, we launched new releases of Windows Live Search, the Windows Live suite of applications and services, and updated our MSN Video Service. In addition, we launched a new release of adCenter and expanded our advertising platform portfolio.

During the first quarter of fiscal year 2008, we completed our acquisition of aQuantive, Inc. (“aQuantive”), a digital marketing business which we expect will play a key role in the development of our advertising business. aQuantive earns revenue from online advertising and from digital marketing and advertising agency services. We believe the acquisition will help us build and support next-generation advertiser and publisher solutions in environments such as cross-media planning, video-on-demand, and Internet protocol television. aQuantive was consolidated into our results of operations starting August 10, 2007, the acquisition date.

Proposed Acquisition of Yahoo! Inc.

To accelerate our advertising strategy, during fiscal year 2008 we submitted a proposal to the Yahoo! Inc. board of directors to acquire all of the outstanding shares of Yahoo!. After careful consideration, we determined that the price demanded by Yahoo! was not in the best interest of our shareholders and we withdrew our proposal to acquire the

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the year. Consulting, Premier

company. Subsequently, we submitted several proposals to purchase Yahoo!’s search business and Professional product support servicesmake an investment in Yahoo!, all of which were rejected by Yahoo!. We continue to invest heavily in new tools, Web experiences, improved search performance, and advertiser satisfaction, and we will continue to seek to build our scale through organic growth, partnerships, and strategic acquisitions.

Fiscal year 2008 compared with fiscal year 2007

OSB revenue increased $218 million or 15% primarily due to higher demand for services. In fiscal year 2005, Serverdriven by increased online advertising revenue and Server application revenue, including CAL revenue, grew $1.10 billion or 17%. Consulting, Premier, and Professional product support services revenue increased $241 million or 19% compared to the previous year. Foreign currency exchange rate changes accounted for $284 million or three percentage pointsinclusion of total Server and Tools revenue growth, which was offset by a $314 million decline in Upgrade Advantage revenue earned.

Server and Tools operating income increased during fiscal year 2006 primarily reflecting increasedaQuantive revenue, partially offset by decreased access revenue. Online advertising revenue increased sales$553 million or 31%, to $2.3 billion. This increase reflects growth in our existing online advertising business and marketingincludes aQuantive online advertising revenue of $161 million. Agency revenue, which is solely derived from aQuantive, was $345 million during the year. Access revenue decreased $98 million or 28%, to $256 million, reflecting migration of subscribers to broadband or other competitively-priced service providers. As of June 30, 2008, we estimate we had approximately 460 million Windows Live IDs compared with 382 million as of the same date last year.

OSB operating loss increased driven by increased cost of revenue and other operating expenses, partially offset by increased revenue. Cost of revenue increased $796 million or 71%, primarily driven by increased data center and equipment costs, online content expenses, and aQuantive-related expenses. Excluding headcount-related costs, salesSales and marketing expenses increased $274$300 million or 35%, primarily due to additional spending to support long-term strategiesincreased amortization of customer-related intangible assets of $94 million, increased headcount-related expenses, and increased marketing costs. Research and development expenses increased $177 million or 18%, and general and administrative expenses increased $117 million or 175%, primarily related to the launch of SQL Server 2005reflecting increased headcount-related expenses and Visual Studio 2005. Total Servermerger and Tools headcount-related costsacquisition-related expenses. Headcount-related expenses increased 5% related to both24%, driven by an 11% increase in headcount during the year.

Fiscal year 2007 compared with fiscal year 2006

OSB revenue increased driven primarily by advertising revenue which grew $283 million or 19%, to $1.8 billion. This increase was primarily due to growth in advertising for search, home page, email, and anmessaging services. The increase in salaries and benefits for existing headcount,advertising revenue was partially offset by a $156 million or 31% decrease in stock-based compensation expense. In fiscal year 2005, Serveraccess revenue.

OSB operating loss increased driven primarily by increased cost of revenue which grew $336 million or 42%, and Tools operating income increased headcount-related expenses as a result of continued search and advertising platform investments. The increase in cost of revenue was primarily due todriven by increased revenuedata center costs, online content expenses, and a $1.07 billion decrease in stock-based compensation expense. This increase was partially offsetroyalties. Headcount-related expenses increased 31%, driven by an increase in sales and marketing costs and headcount-related costs as a result of increased headcount and anduring the year.

Fiscal Year 2009 Outlook

We expect revenue, including advertising revenue, to increase in salaries and benefits for existing headcount.fiscal year 2009 as we begin to see returns from investments we have made, including our acquisition of aQuantive. We also expect operating expenses to increase as we continue to invest in our long-term strategy.

Information WorkerMicrosoft Business Division

 

(In millions, except percentages)  2006  2005  2004  

Percent
Change 2006

versus 2005

  

Percent
Change 2005

versus 2004

  2008  2007  2006  

Percentage
Change 2008

versus 2007

 

Percentage
Change 2007

versus 2006

 

Revenue

  $11,756  $11,169  $10,748  5%  4%  $18,932  $16,402  $14,465  15% 13%

Operating income

  $8,285  $8,025  $7,458  3%  8%  $12,358  $10,777  $9,534  15% 13%

Information Worker primarily consistsMicrosoft Business Division (“MBD”) offerings consist of the Microsoft Office system of programs, servers, solutions, and servicesMicrosoft Dynamics business solutions. Microsoft Office system products are designed to increase personal, team, and organization productivity. Information Worker includesproductivity through a range of programs, services, and software solutions. Growth of revenue from the Microsoft Office Microsoft Project, Microsoft Visio, SharePoint Portal Server CAL, and other information worker products including Office Communications Server and OneNote. Revenue growthsystem offerings, which generate over 90% of MBD revenue, depends on theour 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.

Information Worker revenue increased in fiscal year 2006 primarily reflecting a $521 million or 5% increase in volume licensing, retail packaged products, and preinstalled versions of Office in Japan, while OEM revenue increased $66 million or 4%. Information Worker revenue increased in fiscal year 2005 primarily reflecting a $269 million or 3% increase in volume licensing, retail packaged product, and pre-installed versions of Office in Japan, a $91 million or 6% increase in OEM revenue, and the impact of foreign currency exchange rates, partially offset by reduced Upgrade Advantage earned revenue. Changes in foreign currency exchange rates accounted for approximately $367 million or three percentage points of the revenue growth for fiscal year 2005, offset by a $663 million decline in Upgrade Advantage earned revenue.

Information Worker operating income increased in fiscal year 2006 primarily due to the revenue growth, partially offset by a $283 million or 15% increase in sales and marketing expenses related to supporting field sales efforts and a $71 million or 10% increase in research and development expenses. Headcount-related costs increased 14% during fiscal year 2006 reflecting both an 18% increase in headcount related to supporting field sales efforts and research and development investments in future products and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. Information Worker operating income growth for fiscal year 2005 was primarily due to the revenue growth and a $304 million decrease in stock-based compensation expense. Operating expenses were also impacted by a reduction in marketing campaign costs from the previous period associated with the launch of Office 2003. This decline was offset by an increase in headcount-related costs as a result of an increase in headcount and an increase in salaries and benefits for existing headcount. Microsoft

 

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Microsoft Business Solutions

(In millions, except percentages)  2006  2005  2004  

Percent
Change 2006

versus 2005

  

Percent
Change 2005

versus 2004

Revenue

  $919  $784  $742  17%  6%

Operating income (loss)

  $24  $(171) $(291) *  41%
*Not meaningful

Microsoft Business Solutions provides business management software solutions targeted to businesses of varying sizes. The main products consist of enterprise resource planning (“ERP”) solutions, customer relationship management (“CRM”) software, retail solutions, Microsoft Partner Program (“MSPP”), and related services. Microsoft Business Solutions also includes the Small and Mid-market Solutions and Partners (“SMS&P”), which focuses on sales to customers and partners in the small and mid-market customer segments. Revenue is derived from software and services sales, with software sales representing a significant amount of total revenue. Software revenues include both new software licenses and enhancement plans, which provide customers with future software upgrades over the period of the plan. Our solutions are delivered through a worldwide network of channel partners that provide services and local support.

Microsoft Business Solutions revenue increased in fiscal year 2006 driven by new users for Microsoft CRM and existing Dynamics ERP customers purchasing functionality and user licenses. The increase in Microsoft Business Solutions revenue in fiscal year 2005 was mainly due to 10% revenue growth in software partially offset by 25% decline in services revenue. The software revenue increase was driven by 9% growth in license revenue and 16% growth in enhancement revenue and was attributed to growth in ERP and CRM solutions and an increase in MSPP subscriptions.

Microsoft Business Solutions operating income increased in fiscal year 2006 reflecting the increase in revenue accompanied by a $56 million decrease in sales and marketing expense as a result of decreased net SMS&P spending. Headcount-related costs increased 3% reflecting both a 10% increase in headcount and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. Microsoft Business Solutions operating loss declined in fiscal year 2005 primarily due to a $175 million decline in stock-based compensation expense, an increase in product revenue, and a decline in amortization of acquired intangibles. The reduction in operating loss was partially offset by a net increase in sales and marketing expense driven by incremental costs in the SMS&P organization. In addition, we increased our marketing and product development spending in our ERP and CRM portfolios.

MSN

(In millions, except percentages)  2006  2005  2004  

Percent
Change 2006

versus 2005

  

Percent
Change 2005

versus 2004

Revenue

  $2,298  $2,344  $2,270  (2)%  3%

Operating income (loss)

  $(77) $412  $98  *  320%
*Not meaningful

MSN includes personal communications services, such as e-mail and instant messaging, and online information offerings, such as MSN Search, and the MSN portals and channels around the world. MSN also provides a variety of online paid services in addition to MSN Internet Access and MSN Premium Web Services. Revenue is derived primarily from advertisers on MSN, from consumers and partners through subscriptions and transactions generated from online paid services, and from MSN narrowband Internet access subscribers. In fiscal year 2006, we launched MSN adCenter – our internally developed advertising platform – in certain international markets and throughout the U.S. where it now serves 100 percent of paid search traffic on our online properties. We believe MSN adCenter will enable us to increase both display and search advertising revenues by reducing our reliance on third parties for delivering ads. Effective July 1, 2005, functions related to MapPoint previously reported in Mobile and Embedded

 

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Devices were moved

Dynamics products provide business solutions for financial management, customer relationship management, supply chain management, and analytics applications for small and mid-size businesses, large organizations, and divisions of global enterprises. We evaluate our results based upon the nature of the end user in two primary parts: business revenue, which includes Microsoft Office system revenue generated through volume licensing agreements and Microsoft Dynamics revenue, and consumer revenue, which includes revenue from retail packaged product sales and OEM revenue. In April 2008, we completed our acquisition of Fast Search & Transfer ASA (“FAST”), an enterprise search company. We believe the acquisition will broaden our enterprise search technology product offerings to MSN. Mobilebusinesses and Embedded Deviceswill enable innovations in related areas such as our portal and MSN operating results for the prior periods have been restated for this reorganization. We announced incontent management.

Fiscal year 2008 compared with fiscal year 2006, Windows Live™, a set of Internet services and software designed to improve the users’ connected experience, including Windows Live™ Local and Windows Live Messenger.2007

MSN revenue decreased in fiscal year 2006 primarily reflecting a $195 million or 28% decline in access revenue, partially offset by a $126 million or 9% increase in advertising revenue and a $23 million or 9% increase in revenue from subscription and transaction services other than access. As of June 30, 2006, MSN had 2.1 million access subscribers compared with 2.7 million at June 30, 2005. In addition, MSN had over 261 million active Hotmail accounts and over 243 million active Messenger accounts as of June 30, 2006. The increase in advertising revenue reflects growth in display advertising for portals, channels, email, and messaging services, which was partially offset by a decline in search revenue due to the transition to adCenter. In fiscal year 2005, MSNMBD revenue increased reflecting $193growth in licensing of the 2007 Microsoft Office system and included a favorable impact from foreign currency exchange rates of $724 million or 16% growth in advertisingfour percentage points. Business revenue increased $2.6 billion or 21%, primarily as a result of industry and market growth and continued growth of MSN display advertisingin volume licensing agreement revenue and $84strong transactional license sales to businesses. The increase in business revenue also included a 21% increase in Microsoft Dynamics customer billings. Consumer revenue decreased $80 million or 88%2%, reflecting the consumer launch of the 2007 Microsoft Office system in the prior fiscal year.

MBD operating income increased reflecting growth in subscription and transaction services revenue. These increases wererevenue, partially offset by the search clarity in advertising program, the impact of the homepage redesign,increased sales and a decline of $219 million or 24% in access revenue, driven by the continued migration of Internet Access subscribers to broadband or other competitively priced Internet service providers.

MSN operating income decreased in fiscal year 2006 due to a $230 million or 39% increase inmarketing expenses, research and development costs, a $126expenses, and cost of revenue. Sales and marketing expenses increased $462 million or 22%13%, reflecting increased expenses associated with our corporate sales force. Research and development expenses increased $228 million or 18%, primarily driven by an increase in headcount-related expenses and a $35 million in-process research and development expense related to the acquisition of FAST. Cost of revenue increased $225 million or 29%, primarily driven by an increase in online services infrastructure costs and product costs related to retail packaged product sales. Headcount-related expenses increased 10%, driven by an increase in headcount during the year.

Fiscal year 2007 compared with fiscal year 2006

MBD revenue increased primarily reflecting licensing of the 2007 Microsoft Office system and included a favorable impact from foreign currency exchange rates of $247 million or two percentage points. Revenue from consumer sales increased $339 million or 10% while revenue from business sales increased $1.6 billion or 15%. The increase in business revenue included a 21% increase in Microsoft Dynamics customer billings.

MBD operating income increased reflecting the increased revenue, partially offset by increased sales and marketing expenses and cost of revenue primarily associated with the 2007 Microsoft Office system. The increase in sales and marketing expenses reflected increased headcount-related expenses, increased sales support costs from our Enterprise Software Advisor channel partners, and a $67 million or 9% increase in cost of revenue as we continue to invest in MSN adCenter, Windows Live, and other new platforms.increased launch-related marketing expenses. Headcount-related costsexpenses increased 25% reflecting a 44%8%, driven by an increase in headcount and increased salaries and benefits for existing employees, partially offset by a decrease in stock-based compensation. In fiscal year 2005, MSN operating income increased mainly due to a $241 million decrease in stock-based compensation expense, reduced costs associated withduring the Internet Access business, and increased advertising and subscription revenue. Partially offsetting the decreased expenses were increased headcount-related costs as a result of increased headcount and an increase in salaries and benefits for existing headcount.year.

Mobile and Embedded Devices

(In millions, except percentages)  2006  2005  2004  

Percent
Change 2006

versus 2005

  

Percent
Change 2005

versus 2004

Revenue

  $377  $262  $193  44%  36%

Operating income (loss)

  $2  $(65) $(237) *  73%

* Not meaningfulFiscal Year 2009 Outlook

Mobile and Embedded Devices includes Windows Mobile software, Windows Embedded operating systems, and Windows Automotive. These products extend the advantages of the Windows platformWe expect revenue to mobile devices such as PDAs, phones, and a wide range of embedded devices. The business is also responsible for managing sales and customer relationships for Microsoft overall with device manufacturers and communication sector customers. The communication sector includes network service providers (such as wireless, wireline and cable operators) and media and entertainment companies. The market for products in these segments is intensely competitive. Competitive alternatives vary based on product lines and include product offerings from commercial and non-commercial mobile operating system providers, and proprietary software developed by OEMs and mobile operators. Effective July 1, 2005, functions relatedcontinue to MapPoint previously reported in Mobile and Embedded Devices were moved to MSN. Mobile and Embedded Devices and MSN operating results forincrease over the prior periods have been restated for this reorganization.

Mobile and Embedded Devices revenue increased in fiscal year 2006 primarily due to unit volume increases in major product lines, especially Windows Mobile software sales and Windows Embedded operating systems. Increased revenue for Windows Mobile software was primarily driven by increased market demand for phone-enabled devices, partially offset by a decline in shipments for stand-alone PDAs. In fiscal year 2006, revenue for Windows Mobile software increased $55 million or 37% while revenue for Windows Embedded operating systems increased $49 million or 47%, which was primarily due to the product being includedstrong performance of the 2007 Microsoft Office system and business demand for other applications. Fiscal year 2009 represents an important year in new product designs for both newdelivering on our software plus services strategy with the upcoming releases of Exchange Online, SharePoint Online, and existing customers. Unit volume increases in major product lines drove revenue growth for fiscal year 2005 over fiscalOffice Communication Server Online.

Entertainment and Devices Division

(In millions, except percentages)  2008  2007  2006  

Percentage
Change 2008

versus 2007

  

Percentage
Change 2007

versus 2006

 

Revenue

  $8,140  $6,069  $4,732  34%  28%

Operating income (loss)

  $426  $(1,969) $(1,339) *  (47)%
*

Not meaningful

 

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year 2004, primarily driven by increased market demand for phone-enabled devices, and increased growth in shipments for standalone PDAs. In fiscal year 2005, revenue for Windows Mobile software increased $46 million or 45% and revenue for Windows Embedded operating systems increased $19 million or 21%. Unit volume increases in major product lines drove revenue growth for fiscal year 2005 over fiscal year 2004, primarily driven by increased market demand for phone-enabled devices, and increased growth in shipments for standalone PDAs.

Mobile and Embedded Devices generated operating income for fiscal year 2006 as opposed to the operating loss in fiscal year 2005 primarily due to increased revenue, partially offset by a $42 million or 21% increase in both research and development and general and administrative expenses. Headcount-related costs increased 15% reflecting both a 24% increase in headcount and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. The operating loss for fiscal year 2005 decreased compared to fiscal year 2004 primarily due to a $95 million decrease in stock-based compensation, as well as the growth in revenue and a decrease in sales and marketing expense. This improvement was partially offset by increased salary and benefit costs from increased headcount, and increased investment in research and development.

Home and Entertainment

 

(In millions, except percentages)  2006  2005  2004  

Percent
Change 2006

versus 2005

  

Percent
Change 2005

versus 2004

Revenue

  $4,256  $3,140  $2,737  36%  15%

Operating loss

  $(1,262) $(485) $(1,337) (160)%  64%

HomeEntertainment and EntertainmentDevices 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, CPxG (consumeronline 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),products including application software for Macintosh computers and TV platformMicrosoft PC hardware products, and is responsible for the interactive television industry. The success of video game consoles is determined by console innovation, the portfolio of video game contentall retail sales and marketing for the console, online offerings,Microsoft Office and the market share of the console. Our Xbox business is transitioningWindows operating systems. In April 2008, we acquired Danger, Inc. (“Danger”), a software-as-a-service company that provides mobile operators with an integrated end-to-end solution to a new console, thedeliver mobile data and Internet services to their subscribers.

Fiscal year 2008 compared with fiscal year 2007

EDD revenue increased primarily due to increased Xbox 360 which launched in the second quarter of fiscal year 2006. We believe that the functionality of our new console, games portfolio,platform sales. Xbox 360 platform and online offerings are well-positioned relative to forthcoming competitive consoles. We also believe launching in advance of competitive consoles will provide a strategic advantage for the long-term success of Xbox 360. Revenue from the first generation of Xbox products has declined and is expected to continue to declinePC game revenue increased $1.7 billion or 41% as a result of the introduction of Xbox 360.

Home and Entertainment revenue increased in fiscal year 2006 primarily due to the launch of the Xbox 360 console partially offset by a decline in first party Xboxsales, video game sales primarily resulting from the significant impact ofled by Halo 2 in fiscal year 2005.3, Xbox Live revenue, and Xbox 360 accessory sales. We sold approximately 5shipped 8.7 million Xbox 360 consoles during fiscal year 2006. The2008, compared with 6.6 million Xbox 360 consoles during fiscal year 2007.

EDD operating income increased primarily due to increased revenue growth was also attributable to $140and decreased cost of revenue, partially offset by increased research and development expenses and sales and marketing expenses. Cost of revenue decreased $683 million or 15% growth from our other13%, reflecting the impact of the $1.1 billion Xbox 360 charge in fiscal year 2007 (which primarily related to the warranty expansion), partially offset by increased Xbox 360 product lines,costs related to increased unit console sales. Research and development expenses increased $242 million or 18%, primarily reflecting increased headcount-related expenses and costs related to the acquisition of Danger, including a $24 million in-process research and development expense. Sales and marketing expenses increased $93 million or 8%, primarily reflecting increased headcount-related expenses and increased bad debt expense. Headcount-related expenses increased 21%, driven by an increase in headcount during the year.

Fiscal year 2007 compared with fiscal year 2006

EDD revenue increased primarily due to increased Xbox 360 platform and Zune sales. We shipped 6.6 million Xbox 360 consoles during fiscal year 2007 as compared to 5.0 million consoles during fiscal year 2006. Xbox and PC game revenue increased $650 million or 19% as a result of an increaseincreased Xbox 360 platform sales, partially offset by decreased sales of the first generation Xbox console and related accessories and video games. Zune, consumer hardware and software, and Mediaroom revenue increased $539 million or 65% primarily driven by the Zune launch in PC games sales due to significant new game releases, especially “Age of Empires III”, and an increase in MSTV revenue due to deployments in fiscal yearNovember 2006. Revenue

EDD operating loss increased in fiscal year 2005 primarily due to significant new product launches, which resulted in a $416 million or 23% increase inthe $1.1 billion Xbox revenue. Halo 2 was introduced360 charge recognized in the secondfourth quarter of fiscal year 20052007 and generated over $300 million in revenue in fiscal year 2005. Revenue from consumer hardware and software, PC games, and TV platforms declined $50 million or 5% compared to fiscal year 2004 due to lower PC games software sales.

Home and Entertainment operating loss increased in fiscal year 2006 primarily as a result of a $1.64 billionZune launch-related expenses. The increase in cost of revenue resulting from the number of Xbox 360 consoles sold and higher Xbox 360 unit costs, partially offset by the revenue growth. Our fiscal year 2006 operating loss increased due to the significant impact of Halo 2 in fiscal year 2005. Headcount-related costs increased 5% reflecting both a 19% increase in headcount and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. The fiscal year 2005 operating loss decreased primarily due to an increase in high margin Xbox software sales, lower Xbox console units costs, a $90 million lower-of-cost-or-market inventory adjustment recorded in fiscal year 2004, and a $219 million decrease in stock-based compensation expense. The decrease was partially offset by increased Xbox 360 platform sales and decreased Xbox 360 console manufacturing costs. Headcount-related expenses increased 14%, driven by an increase in costs associated with Xbox 360 console developmentheadcount during the year.

Fiscal Year 2009 Outlook

We expect revenue to be flat or to decrease due to year-over-year variations in product launches, volume, mix, and related launch efforts.

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prices across our portfolio of products and services. We expect sustained profitability for fiscal year 2009.

Corporate-Level Activity

 

(In millions, except percentages)  2006  2005  2004  

Percent
Change 2006

versus 2005

 

Percent
Change 2005

versus 2004

   2008 2007 2006 

Percentage
Change 2008

versus 2007

  

Percentage
Change 2007

versus 2006

Corporate-level expenses

  $5,026  $5,910  $6,871  (15)% (14)%

Corporate-level activity

  $(6,704) $(4,777) $(4,804) (40)%  1%

Certain corporate-level activity, including expenses are not allocatedrelated to our segments. Those expenses primarily include corporate operations related toassociated with broad-based sales and marketing, product support services, human resources, legal, finance, information technology, corporate development and procurement activities, research and development and other costs, and legal settlements and contingencies.contingencies, is not allocated to our segments.

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Fiscal year 2008 compared with fiscal year 2007

Corporate-level expenses decreased inincreased during fiscal year 2006, primarily2008, reflecting a $991 million decrease inincreased costs for legal settlements and legal contingencies partially offset by an $84 millionand a 12% increase in headcount-related costs.expenses. We incurred $1.32$1.8 billion of legal charges during the year primarily related to the European Commission fine of $1.4 billion (899 million) as compared with $511 million of legal charges during the prior year. The increase in headcount-related expenses reflects an increase in headcount during the year.

Fiscal year 2007 compared with fiscal year 2006

Corporate-level expenses increased primarily driven by increased headcount-related expenses offset by decreased costs for legal settlements and legal contingencies. Headcount-related expenses increased 25%, driven by an increase in headcount and an increase in salaries and benefits for existing headcount. We incurred $511 million in legal charges during fiscal year 2007, primarily related to antitrust and unfair competition consumer class actions, intellectual property claims, and an extension payment to Sun Microsystems, Inc. under our Limited Patent Covenant and Standstill Agreement. We incurred $1.3 billion in legal charges during fiscal year 2006 includingwhich included settlement expense of $361 million related to our settlement with RealNetworks, Inc. as well as other intellectual property and antitrust matters, and thea $351 million (281 million ($351 million) fine imposed by the European Commission in July 2006 related to its 2004 decision in its competition law investigation of Microsoft, as compared to $2.31 billion in legal charges incurred during the prior year primarily related to settlements with Novell, Inc., Gateway, IBM, and other antitrust and competition law matters. Headcount-related costs increased 5% during the twelve months ended June 30, 2006 reflecting both a 23% increase in headcount and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation.

Corporate-level expenses decreased in fiscal year 2005, primarily as a result of a $736 million reduction in stock-based compensation expense and decreased costs for legal settlements and legal contingencies. In fiscal year 2005, we recognized $2.31 billion in legal charges as comparedextension payment to $2.53 billion in fiscal year 2004 which included a $1.92 billion charge for a settlement with the Sun Microsystems, Inc., and the fine of497 million ($605 million) imposed by the European Commission.

Change to Financial Reporting Structure

On July 17, 2006, we announced that effective the first quarter of fiscal year 2007, we will report our businesses under five operating segments, reflecting completion of the previously announced changes in our organizational structure and how we will manage our business beginning in fiscal year 2007. Each of the five segments will be organized under one of the three operating divisions announced earlier in fiscal year 2006:

Platforms and Services Division

Microsoft Business Division

Entertainment and Devices Division

The five operating segments are described below. The first three of these will comprise the Platforms and Services Division.

Client    will include the former Client segment. Products will include Windows XP Professional and Home, Media Center Edition, Tablet PC Edition, and other standard Windows operating systems.

Server and Tools    will include the former Server and Tools segment, excluding the Exchange Server business and certain client access licenses related to products residing in the Microsoft Business Division. Products will include the Windows Server operating system, Microsoft SQL Server, Microsoft Consulting Services, product support services, Visual Studio, System Center products, the Forefront security family of products, and Biz Talk Server, among others.

Online ServicesBusiness    will include the former MSN segment and Windows Live. Products will include MSN Search, MapPoint, MSN Internet Access, MSN Premium Web Services, MSN Mobile Services, and Windows Live.

Microsoft Business Division    will include the former Information Worker and Microsoft Business Solutions segments, as well as the Exchange Server business and certain client access licenses, formerly included in the Server and Tools segment. Products will include Microsoft Office, Microsoft Project, Microsoft Visio, SharePoint Portal Server CAL, Microsoft Live Meeting, One Note, Office Communication Server, Microsoft Dynamics AX, Microsoft

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Dynamics CRM, Microsoft Dynamics GP, Microsoft Dynamics NAV, Microsoft Dynamics SL, Microsoft Dynamics Retail Management System, Microsoft Partner Program, and Microsoft Office Small Business Accounting.

Entertainment and Devices Division    will include the former Home and Entertainment and Mobile and Embedded Devices segments. Products will include Xbox 360, Xbox, Xbox Live, CPxG (consumer software and hardware products), IPTV, Windows Mobile software platform, Windows Embedded device operating system, and Windows Automotive.

Our historical results under this new segmentation for the four quarters in fiscal years 2006 and 2005 were as follows:

Revenue

  For the quarter ended    For the quarter ended  
     
(In millions) September 30,
2005
 December 31,
2005
 March 31,
2006
 June 30,
2006
 Fiscal Year
2006
  September 30,
2004
 December 31,
2004
 March 31,
2005
 June 30,
2005
 Fiscal Year
2005
     

Segments

           

Client

 $3,187 $3,459 $3,187 $3,376 $13,209  $2,980 $3,193 $2,964 $3,014 $12,151

Server and Tools

  2,127  2,438  2,398  2,690  9,653   1,906  2,161  2,058  2,245  8,370

Online Services Business

  564  594  561  580  2,299   559  606  581  598  2,344

Microsoft Business Division

  3,283  3,689  3,608  3,908  14,488   3,086  3,413  3,384  3,637  13,520

Entertainment and Devices

  580  1,657  1,146  1,250  4,633   658  1,445  633  667  3,403
     

Total revenue

 $9,741 $11,837 $10,900 $11,804 $44,282  $9,189 $10,818 $9,620 $10,161 $39,788
     

Operating Income / (Loss)

  For the quarter ended     For the quarter ended    
      
(In millions) September 30,
2005
  December 31,
2005
  

March 31,

2006

  

June 30,

2006

  Fiscal Year
2006
  September 30,
2004
  December 31,
2004
  

March 31,

2005

  

June 30,

2005

  Fiscal Year
2005
 
      

Segments

          

Client

 $2,569  $2,638  $2,471  $2,504  $10,182  $2,387  $2,513  $2,331  $2,172  $9,403 

Server and Tools

  606   762   746   903   3,017   455   660   515   479   2,109 

Online Services Business

  81   58   (26)  (190)  (77)  79   130   101   101   411 

Microsoft Business Division

  2,251   2,466   2,414   2,544   9,675   2,160   2,355   2,316   2,285   9,116 

Entertainment and Devices

  (182)  (296)  (422)  (437)  (1,337)  (202)  28   (198)  (235)  (607)

Corporate-Level Activity

  (1,279)  (971)  (1,295)  (1,443)  (4,988)  (1,385)  (937)  (1,736)  (1,813)  (5,871)
      

Total operating income

 $4,046  $4,657  $3,888  $3,881  $16,472  $3,494  $4,749  $3,329  $2,989  $14,561 
      

Our outlook for fiscal year 2007 based on the five operating segments is as follows:

Client    We expect revenue to grow reflecting improvement in the commercial and retail portion of the business due to our upcoming launch of Windows Vista. We expect revenue generated from OEMs to grow slower than the PC hardware market due to increased concentration among larger OEMs, consumer hardware shipments growing faster than business shipments, and relatively faster growth in emerging markets. We expect PC shipments to grow 8% to 10% for fiscal year 2007. We believe that PC unit growth rates will be higher in the consumer segment than in the business segment and higher in emerging markets than in mature markets.

Server and Tools    We expect continued momentum from recent product launches and the expansion of our products in security, management and designer tools will help drive our overall revenue growth in fiscal year 2007. We estimate overall server hardware unit shipments will grow 10% to 12% in fiscal year 2007. However, we face competition from Linux-based, Unix, and other server operating systems as well as competition in server applications.

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Online Services Business    We expect increased growth in display advertising revenue as the portals, channels, and communications services continue to expand globally and the overall Internet advertising industry continues to expand. Our search revenue is expected to grow in fiscal year 2007 as a result of continued ramp up of adCenter. We expect revenue from narrowband Internet Access to continue to decline in fiscal year 2007.

Microsoft Business Division    We expect Microsoft Business Division revenue to grow in fiscal year 2007. We feel that our customers’ continued preference to purchase annuity contracts indicates enthusiasm for the 2007 Microsoft Office system. We also expect continued demand for our Dynamics products, building on the fiscal 2006 momentum.

Entertainment and Devices Division    We expect revenue to increase from fiscal year 2006 due to the increased availability of the Xbox 360 console unit during the entire fiscal year, including the second holiday season after the launch in fiscal year 2006. In fiscal year 2007, we expect to introduce a music and entertainment device, the first in a new family of hardware and software products for the consumer market. The availability of a commercial IPTV product is expected to drive significant growth in MSTV revenue across several geographies. Revenue from existing mobility and embedded devices is expected to increase due to unit volume increases of Windows Mobile software driven by increased market demand for phone-enabled devices and Windows Embedded operating systems. Short product life cycles in product lines such as Windows Mobile software may impact our continuing revenue streams. Xbox 360 console unit costs are expected to decline.

As we implement our long-term growth strategy, we expect to increase our level of spending in four key areas in fiscal year 2007: increased product costs associated with Xbox consoles; marketing and field sales spending including launch costs; quickening the pace of development in growth areas such as business intelligence, security, management and unified communications (including acquisitions); and increased costs to execute on our online services strategy. While these investments will translate into increased operating expenses in fiscal year 2007, we believe they will help lay the groundwork for future growth and profitability.

Operating Expenses

Cost of Revenue

 

(In millions, except percentages)  2006  2005  2004  

Percent
Change 2006

versus 2005

  

Percent
Change 2005

versus 2004

  2008 2007 2006 

Percentage
Change 2008

versus 2007

 

Percentage
Change 2007

versus 2006

 

Cost of revenue

  $7,650    $6,031    $6,596    27%    (9)%    $11,598  $10,693  $7,650  8% 40%

As a percent of revenue

   17%   15%   18%  2ppt  (3)ppt   19%  21%  17% (2)ppt 4ppt

Cost of revenue includes manufacturing and distribution costs for products sold and programs licensed, operating costs related to product support service centers and product distribution centers, costs incurred to support and maintain Internet-based products and services, andwarranty costs, inventory valuation adjustments, costs associated with the delivery of consulting services.services, and the amortization of capitalized research and development costs associated with software products that have reached technological feasibility. Cost of revenue increased in fiscal year 20062008, reflecting increased mainly due to a $1.64 billion increasedata center and equipment costs, online content expenses, and increased costs associated with the growth in Home and Entertainment as a result of an increase in the number of total Xbox consoles sold and higherour consulting services, partially offset by decreased Xbox 360 unit costs. CostXbox 360 costs decreased because of revenuethe $1.1 billion charge in fiscal year 2005 decreased due2007 (which primarily related to a $363 million decrease in stock-based compensation expense, a $140 million reduction in costs associated with a decrease in the MSN Internet Access subscriber base, and a $169 million reduction in other product costs mainly due toexpansion of our Xbox consoles cost efficiency,360 warranty coverage), partially offset by increased Xbox 360 product costs, reflecting growth in unit console sales. Cost of revenue increased in fiscal year 2007, primarily driven by the Xbox 360 warranty charge, increased Windows Vista product supportcosts, increased OSB data center costs, and costs associated with the growth in consulting services costs.services.

Research and Development

 

(In millions, except percentages)  2006  2005  2004  

Percent
Change 2006

versus 2005

  

Percent
Change 2005

versus 2004

  2008 2007 2006 

Percentage
Change 2008

versus 2007

 

Percentage
Change 2007

versus 2006

 

Research and development

  $6,584    $6,097    $7,735    8%    (21)%    $8,164  $7,121  $6,584  15% 8%

As a percent of revenue

   15%   15%   21%  –ppt  (6)ppt   14%  14%  15% ppt (1)ppt

PAGE29


 Part II 

Item 7

Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related costsexpenses associated with product development. Research and development expenses also

PAGE31


 Part II 

Item 7

include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content.content, and in-process research and development. Research and development expenses increased during fiscal year 2008 reflecting increased headcount-related expenses, increased product development costs, and in-process research and development expenses related to acquisitions during the year. Headcount-related expenses increased 12% during fiscal year 2008, reflecting an increase in headcount during the year. Research and development costs increased during fiscal year 20062007, primarily due to increased development costs associated with new and upcoming offerings such as MSN adCenter, the 2007 Microsoft Office system, Windows Vista, Xbox 360, and corporate research activities. Headcount-related costs increased 3% during fiscal year 2006headcount-related expenses which grew 8%, reflecting both a 17% increasegrowth in headcount and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. Our research and development expenses decreased in fiscal year 2005 due to a $1.88 billion decrease in stock-based compensation expense. This expense decline was partially offset by increased headcount and product development costs associated withduring the Xbox 360 console and related games, SQL Server 2005, Windows Vista, and product development in Mobile and Embedded Devices.year.

Sales and Marketing

 

(In millions, except percentages)  2006  2005  2004  

Percent
Change 2006

versus 2005

  

Percent
Change 2005

versus 2004

  2008 2007 2006 

Percentage
Change 2008

versus 2007

 

Percentage
Change 2007

versus 2006

 

Sales and marketing

  $9,818    $8,563    $8,195    15%    4%    $13,039  $11,455  $9,818  14% 17%

As a percent of revenue

   22%   22%   22%  –ppt  –ppt   22%  22%  22% ppt ppt

Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related costsexpenses associated with sales and marketing personnel and advertising, promotions, trade shows, seminars, and other programs. Sales and marketing expenses increased during fiscal year 20062008, primarily due toreflecting increased headcount-related costs, investments in partnerexpenses and increased corporate marketing and product launch-related spending.advertising campaigns. Headcount-related costsexpenses increased 13%14% during fiscal year 20062008, reflecting both a 20%an increase in headcount during the year. Sales and marketing expenses increased during fiscal year 2007 primarily because of increased headcount-related expenses and increased marketing costs related to product launches. Headcount-related expenses increased 22% during fiscal year 2007, driven by an increase in salaries and benefits for existing headcount partially offset by a decrease in stock-based compensation expense.

For fiscal year 2005, sales and marketing expense increased slightly due to $470 million higher headcount-related costs from increased headcount and general salary increases; higher sales and marketing costs driven by product planning, reseller marketing, and advertising campaign costs mainly related to launch ofduring the“Start Something” campaign; launch of “Halo 2”; and launch arrangements for Xbox 360. The increase was offset mainly by a $660 million decrease in stock-based compensation expense. year.

General and Administrative

 

(In millions, except percentages)  2006  2005  2004  

Percent
Change 2006

versus 2005

  

Percent
Change 2005

versus 2004

  2008 2007 2006 

Percentage
Change 2008

versus 2007

 

Percentage
Change 2007

versus 2006

 

General and administrative

  $3,758    $4,536    $5,275    17%      14%      $5,127  $3,329  $3,758  54% (11)%

As a percent of revenue

   8%   11%   14%  (3)ppt  (3)ppt   8%  7%  8% 1ppt (1)ppt

General and administrative costs include payroll, employee benefits, stock-based compensation expense and other headcount-related costsexpenses associated with finance, legal, facilities, certain human resources, other administrative headcount, and legal and other administrative fees. General and administrative costs decreased inexpenses increased during fiscal year 2006 primarily2008, reflecting decreasedincreased costs for legal settlements and legal contingencies.contingencies, increased consulting and professional fees, and increased headcount-related expenses. We incurred $1.32$1.8 billion inof legal charges during fiscal year 20062008, primarily related to the European Commission fine of $1.4 billion (899 million) as compared to $2.31 billion inwith $511 million of legal charges incurred during fiscal year 2005.2007. Headcount-related costsexpenses increased 7% during the twelve months ended June 30, 2006fiscal year 2008, reflecting both an 18% increase in headcount during the year. During fiscal year 2007, we incurred $511 million of legal charges primarily related to antitrust and unfair competition consumer class actions, intellectual property claims, and extension payment to Sun Microsystems, Inc. as compared with $1.3 billion of legal charges in fiscal year 2006. Headcount-related expenses increased 15% during fiscal year 2007, driven by an increase in salaries and benefits for existing headcount partially offset by a decrease in stock-based compensation expense. General and administrative costs decreased in fiscal year 2005 primarily reflecting decreased stock-based compensation expense and decreased costs for legal settlements and legal contingencies. In fiscal year 2005, we recognized $277 million of stock-based compensation expense as compared to $664 million in fiscal year 2004. In fiscal year 2005, we recognized $2.31 billion in legal charges as compared to $2.83 billion in fiscal year 2004.during the year.

 

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Item 7

 

Investment Income and Other

The components of investment income and other were as follows:

 

(In millions)  2006 2005 2004   2008 2007   2006   

Percentage
Change 2008

versus 2007

  

Percentage
Change 2007

versus 2006

Dividends and interest

  $1,510  $1,460  $1,892   $888  $1,319   $1,510   (33)%  (13)%

Net gains on investments

   161   856   1,563 

Net losses on derivatives

   (99)  (262)  (268)

Income/(losses) from equity investees and other

   218   13   (25)

Net recognized gains on investments

   346   650    161   (47)%  304%

Net gains (losses) on derivatives

   226   (358)   (99)  *      262%

Other

   (138)  (34)   218   306%  *   
                    

Investment income and other

  $1,790  $2,067  $3,162   $1,322  $1,577   $1,790   (16)%  (12)%
                         
*

Not meaningful

ForFiscal year 2008 compared with fiscal year 2006, dividends2007

Dividends and interest income increased due to higherdecreased reflecting lower interest rates received on our fixed-income investments partially offset byand a reduction in the average balance of interest-bearing investments owned. Net recognized gains on investments, which include other-than-temporary impairments of $312 million during fiscal year 2008 and $25 million during fiscal year 2007, decreased primarily due to declines in equity values as a result of the recent stock market decline. Net gains on derivatives increased primarily due to higher net gains on equity, commodity, and interest rate derivatives. Other of $138 million includes the correction of several immaterial items from prior periods.

Fiscal year 2007 compared with fiscal year 2006

Dividends and interest income declined reflecting a decline in the average balance of dividend and interest-bearing investments as a resultowned, partly offset by higher interest rates received on our fixed-income investments. Net recognized gains on investments, which include other-than-temporary impairments of the $32.64 billion special dividend paid on December 2, 2004, and stock repurchases made throughout$25 million during fiscal year 2006. Dividends2007 and interest income declined $432$408 million in fiscal year 20052006, increased primarily due to the combination of a greater allocation of funds to lower yielding, more liquid asset classes in preparation for the $32.64 billion special dividend paid on December 2, 2004,other-than-temporary impairments and a lower portfolio balance following payment of the special dividend.

For fiscal year 2006, net recognized gains on investments were comprised of net gains on sales of equity investments, net losses on sales of fixed-income investments and other-than-temporary impairments on both equity and fixed-income investments. Net recognized gains decreasedas compared to losses in fiscal year 2006, partly offset by fewer gains on the sale of equity investments. Derivative losses were primarily due to increaseddriven by net losses in time value on sales of fixed-income investments, higher other-than-temporary impairments and fewer net gains on equity investments in the current period as comparedforeign currency contracts used to fiscal year 2005. For fiscal year 2006, other-than-temporary impairments were $408 million, as compared to $152 million in fiscal year 2005. The increase in other-than-temporary impairmentshedge anticipated foreign currency revenues. Other in fiscal year 2006 was driven by planned salesincludes $195 million of certain investments in an unrealized loss position in ordergains that resulted from the restructuring of joint venture relationships between Microsoft and NBC related to raise funds for the $20 billion tender offer announced on July 20, 2006. Net gains on investments declined $707 million in fiscal year 2005 primarily due to greater sales of investments in the previous fiscal year in preparation for the special dividend paid on December 2, 2004. Net gains on investments also include other-than-temporary impairments of $152 million in fiscal year 2005 compared to $82 million in fiscal year 2004. Net realized gains on sales were $1.65 billion in fiscal year 2004 as we moved to more liquid investment asset classes.MSNBC Cable L.L.C. and MSNBC Interactive News, L.L.C.

Investments are considered to be impaired when a decline in fair value is judged to be other than temporary.other-than-temporary. We employ a systematic methodology that considers available evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, among other factors, we evaluate general market conditions, the duration and extent to which the fair value is less than cost, and our intent and ability to hold the investment. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions. Once a decline in fair value is determined to be other than temporary,other-than-temporary, an impairment charge is recorded and a new cost basis in the investment is established.

We lend certain fixed-income and equity securities to enhanceincrease investment income.returns. The loaned securities continue to be carried as investments on our balance sheet. Collateral and/or security interest is determined based upon the underlying security and the creditworthiness of the borrower. Cash collateral is recorded as an asset with a corresponding liability.

We use derivative instruments to manage exposures to interest rates, equity prices, and foreign currency markets and to facilitate portfolio diversification. Net losses on derivatives were as follows:

(In millions)  2006  2005  2004 

Net gain/(losses) on equity derivatives

  $192  $(202) $118 

Net gains on commodity derivatives

   101   46    

Net losses on interest rate derivatives

   (79)  (53)  (102)

Net losses on foreign currency contracts

   (313)  (53)  (284)
          

Net losses on derivatives

  $(99) $(262) $(268)
             

During fiscal year 2006, we experienced lower net losses on derivatives as compared to fiscal year 2005 primarily due to net gains on non-designated equity derivatives in the current fiscal year as compared to net losses in the prior

PAGE33


 Part II 

Item 7

fiscal year and higher net gains on commodity positions in the current fiscal year driven by increases in the related commodity indices. These gains were partially offset by higher net losses in time value on foreign exchange contracts used to hedge anticipated foreign currency revenues and higher net losses on interest rate derivative contracts.

The net gains on equity derivatives during fiscal year 2006 are primarily due to changes in the market value of non-designated equity derivatives. Gains and losses arising from non-designated derivatives not designated as accounting hedges are in large part economically offset by unrealized losses and gains, respectively, in the underlying equity securities which are recorded as a component of other comprehensive income. Commodity derivatives are held for the purpose of portfolio diversification. Net losses related to foreign currency contracts relate primarily to changes in time value of options used to hedge anticipated foreign currency revenues. Additionally, net gains and losses on foreign exchange contracts include the changes in the fair value of derivatives used as economic hedges. These gains and losses are partially offset economically by unrealized losses and gains, respectively, in the underlying assets which are included in other comprehensive income

Net derivative losses in fiscal year 2005 were primarily related to losses on equity derivatives, interest rate derivatives, and foreign currency contracts. During fiscal year 2005, losses related to equity derivatives used to economically hedge against a decline in equity prices were $202 million and losses related to interest rate derivatives were $53 million. These losses were offset by the combination of realized gains on sales of securities and unrealized gains related to increases in the market value of the underlying assets included as a component of other comprehensive income. Net losses related to foreign currency contracts were $53 million, related to changes in time value of options used to hedge anticipated foreign currency revenues and economically hedging foreign currency based investment exposures. Losses related to hedging foreign currency-based investment exposures were offset by unrealized gains in the underlying assets which are included in other comprehensive income. Net losses on derivatives also included gains related to commodity positions used to provide portfolio diversification. Gains on commodity positions were $46 million during fiscal year 2005.

PAGE31


 Part II 

Derivative losses were $268 million in fiscal year 2004 primarily due to net losses in time value on foreign exchange contracts used to hedge anticipated foreign currency revenues.Item 7

In the second quarter of fiscal year 2006, we entered into an agreement with NBC Universal, Inc. (“NBC”) that restructured our joint venture relationships for MSNBC Cable L.L.C. (“CJV”) and MSNBC Interactive News, L.L.C. (“IJV”). As a result, we divested 32% of CJV for $331 million and NBC acquired the right, exercisable in the following two years, to buy the remaining 18% interest. In addition, we modified our agreement with NBC to grant to IJV a U.S. content license and to remove the exclusivity obligation on both NBC and Microsoft for local and non-U.S. news content. As part of the MSNBC restructuring agreements, we paid a $200 million fee to effectively terminate IJV’s prior content license agreement and we also prepaid the remaining $14 million license fee to NBC. In the fourth quarter of fiscal year 2006, NBC exercised its option to buy our remaining 18% interest in CJV. For fiscal year 2006, we recognized a net gain of $195 million related to the above transactions.

Income Taxes

Our effective tax raterates for fiscal yearyears 2008, 2007, and 2006 waswere 26%, 30%, and 31% as compared, respectively. Our effective tax rates are less than the statutory tax rate due to 26% forforeign earnings taxed at lower rates. The decreased rate in fiscal year 2005.2008 resulted from resolution of tax positions related to our settlement with the Internal Revenue Service (“IRS”) for its 2000-2003 examination. This decline was partially offset by the tax effect of the European Commission fine of $1.4 billion (899 million), which was not tax deductible. The fiscal year 2007 rate reflects a recurring effective tax rate of 31%, offset by a $195 million reduction resulting from various changes in tax positions taken in prior periods, related primarily to favorable developments in an IRS position and multiple foreign audit assessments. During fiscal year 2006, we recorded a tax benefit of $108 million from the resolution of state audits. The increased rate in fiscal year 2006 resulted primarilyaudits and recorded a charge of $351 million (281 million) from the European Commission fine of281 million ($351 million) which iswas not tax deductible,deductible.

On July 1, 2007, we adopted the provisions of the Financial Accounting Standards Board (“FASB”) Interpretation No. 48 (“FIN 48”)Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109, which provides a financial statement recognition threshold and measurement attribute for a lower ratetax position taken or expected to be taken in a tax return. Adopting FIN 48 had the following impact on our financial statements: increased current assets by $228 million, long-term assets by $1.1 billion, long-term liabilities by $2.1 billion, and our retained deficit by $395 million; and decreased our income taxes payable by $394 million. As of June 30, 2008, we had $3.2 billion of unrecognized tax benefits of which $2.3 billion, if recognized, would affect our effective tax rate. As of July 1, 2007, we had $7.1 billion of unrecognized tax benefits of which $5.3 billion, if recognized, would affect our effective tax rate. Our policy is to include interest and penalties related to unrecognized tax benefits in income tax expense. Interest totaled $121 million in fiscal year 2005 as a result2008. As of reversalJune 30, 2008 and July 1, 2007, we had accrued interest related to uncertain tax positions of $776$324 million and $863 million, respectively, net of previously accrued taxes upon settling an Internal Revenue Service examination for fiscal year 1997 – 1999 and afederal income tax benefit of $179 million generated by the decision to repatriate foreign subsidiary earnings under a temporary incentive provided by the American Jobs Creation Act of 2004. Our effective tax rate for fiscal year 2004 was 33%.benefits, on our balance sheets.

Financial Condition

Cash, andcash equivalents, and short-term investments totaled $34.16$23.7 billion and $37.75$23.4 billion as of June 30, 2006,2008 and 2005,2007, respectively. This investment portfolio consistsEquity and other investments were $6.6 billion and $10.1 billion as of June 30, 2008 and 2007, respectively. Our investments consist primarily of fixed-income securities, diversified among industries and individual issuers. Our investments are generally liquid and investment grade. The portfolio is invested predominantly in U.S.-dollar-denominated securities, but also includes foreign currency positionsforeign-denominated securities in order to diversify financial risk. The portfolio is primarily invested in short-term securities to facilitate rapid deployment for immediate cash needs. Equity and other investments were $9.23 billion and $11.00 billion as of June 30, 2006, and 2005, respectively. 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 $18.90$26.6 billion at June 30, 2006.2008. Our retained deficit is not expected to impact our future ability to operate or pay dividends given our continuing profitability and strong cash and financial position.

PAGE34
In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to price positions. This pricing methodology applies to exchange-traded mutual funds, domestic and international equities, U.S. treasuries, and agency securities. If quoted prices in active markets for identical assets or liabilities are not available to price positions, then we use inputs other than the quoted prices that are observable either directly or indirectly. Assets and liabilities measured using unobservable inputs are an immaterial portion of our portfolio.


 Part II 

Item 7

While we own certain mortgage- and asset-backed fixed-income securities, our portfolio as of June 30, 2008 does not contain direct exposure to subprime mortgages or structured vehicles that derive their value from subprime collateral. The majority of the mortgage-backed securities are collateralized by prime residential mortgages and carry a 100% principal and interest guarantee, primarily from Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and Government National Mortgage Association. The remainder of the mortgage position is collateralized by high quality international prime residential mortgage loans.

Unearned Revenue

Unearned revenue from volumeis comprised of the following items:

Volume licensing programs represents – Represents customer billings for multi-year licensing arrangements, paid either upfront or annually at the beginning of each billing coverage period, thatwhich are accounted for as subscriptions with revenue recognized ratably over the billing coverage period. For certain other licensing arrangements revenue attributable to undelivered

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 Part II 

Item 7

Undelivered elements including – Represents free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis,basis. This revenue deferral is applicable for Windows XP and prior versions shipped as retail packaged products, products licensed to original equipment manufacturers (“OEM”), and perpetual licenses for current products under our Open and Select volume licensing programs. The amount recorded as unearned is based on the sales price of those elements when sold separately and is recognized ratably on a straight-line basis over the related product’s life cyclecycle. The percentage of revenue recorded as unearned due to undelivered elements ranges from approximately 15% to 25% of the related product. sales price for Windows XP Home and approximately 5% to 15% of the sales price for Windows XP Professional, depending on the terms and conditions of the license and prices of the elements. Product life cycles are currently estimated at three and one-half years for Windows operating systems.

Other unearned revenue includes – Represents payments for post-delivery support and consulting services TV Platform,to be performed in the future, online advertising for which the advertisement has yet to be displayed, Microsoft Business Solutions, advertising,Dynamics business solutions products, Xbox Live subscriptions, Mediaroom, and subscriptionsother offerings for which we have been paid upfront and earn the revenue when we provide the service or software, or otherwise meet the revenue recognition criteria.

Unearned revenue as of June 30, 2006, increased $1.74 billion from June 30, 2005, reflecting additions to unearned revenue from multi-year licensing that outpaced recognitions by $1.66 billion, a $53 million decrease in revenue deferred for undelivered elements, and a $127 million increase primarily in unearned revenue for services and subscription services.

The following table outlines the expected recognition of $10.9 billion of unearned revenue as of June 30, 2006:2008:

 

(In millions)  Recognition of
Unearned Revenue
  Recognition of
Unearned Revenue

Three months ended:

    

September 30, 2006

  $3,483

December 31, 2006

   2,687

March 31, 2007

   1,899

June 30, 2007

   1,069

September 30, 2008

  $5,120

December 31, 2008

   4,033

March 31, 2009

   2,775

June 30, 2009

   1,469

Thereafter

   1,764   1,900

Unearned revenue

  $10,902  $15,297
      

Cash Flows

Fiscal year 2008 compared with fiscal year 2007

Cash flow from operations for fiscal year 2006 decreased 13% to $14.40increased $3.8 billion primarily due to increased payments to fund a $987 million increase in inventory and product costs related to Xbox 360 and increased payments to employees resulting from a 16% growth in headcount. These factors were partially offset by increased cash receipts from customers driven by our 11% revenue growth and $1.74 billion increase in unearned revenue. Cash used in financing was $20.56 billion in fiscal year 2006, a decrease of $20.52 billion from the previous year driven by a $32.57 billion reduction in cash dividend payments. This impact was partially offset by an $11.15 billion increase in common stock repurchases. Net cash from investing was $8.00 billion in fiscal year 2006, a decrease of $7.02 billion from fiscal year 2005 driven primarily by an $8.93 billion decrease in cash from combined purchase, sales, and maturities of investments and a $766 million increase in additions to property and equipment. These factors were partially offset by $3.12 billion of cash proceeds from our securities lending program.

Cash flow from operations for fiscal year 2005 increased 14% to $16.61 billion primarily due to an increase in cash receiptsreceived from customers driven by our 8%18% revenue growth, combined with a 12% increase in unearned revenue. Cash payments in fiscal year 2005 resulting from significant legal settlements were approximately $1.8partially offset by the $1.4 billion lower than in(899 million) payment of the previous year, adding to the overall increase in operating cash flow. Partially offsetting these factors were increased payments to employees resulting from a 7% increase in full-time employees.European Commission fine. Cash used for financing was $41.08decreased $11.6 billion in fiscal year 2005, driven by $36.11 billion of cash dividends paid in fiscal year 2005 compared to $1.73 billion paid in fiscal year 2004. The increase was also partially driven by $8.06 billion in cash used for common stock repurchases, an increase of $4.67 billion in cash used for share repurchases compared to the previous year, reflecting 312 million shares repurchased in fiscal year 2005, an increase of 188.5 million shares compared to the previous year. Net cash from investing was $15.03 billion in fiscal year 2005, an increase of $18.37 billion from fiscal year 2004, primarily due to a $23.59$15.0 billion increasedecrease in investment maturities that occurred to fund cash dividends paid in fiscal year 2005,common stock repurchases, partially offset by a $5.32$3.3 billion decrease in cash proceeds from the issuance of common stock. Cash used for investing was $4.6 billion for fiscal year 2008 as compared with cash provided of $6.1 billion for fiscal year 2007. This decrease was primarily due to a $6.9 billion increase in cash paid for acquisition of companies, reflecting the purchase of aQuantive in the first quarter of fiscal year 2008, a $918 million increase in purchases of property and equipment, and a $3.1 billion decrease in cash from combined investment purchasepurchases, sales, and sale activity.maturities.

As a result of our settlement related to the 2000-2003 examination, we paid the IRS approximately $3.1 billion during the first quarter of fiscal year 2009.

Fiscal year 2007 compared with fiscal year 2006

Cash flow from operations increased $3.4 billion due to an increase in cash received from customers driven by 15% revenue growth, along with a $1.6 billion decrease in cash outflow for other current assets primarily reflecting changes in inventory. Cash used for financing increased $4.0 billion. Several events occurred during fiscal year 2007 affecting cash used for financing. We issued $6.8 billion of common stock, including $3.3 billion related to 113 million call options exercised by JPMorgan in December 2006. We also completed our tender offer on August 17, 2006, which was included in the $27.6 billion of common stock repurchases. Cash from investing decreased $1.9 billion due to a $3.5 billion decline in securities lending activity where cash collateral is received from the counterparty along with $1.2 billion spent on acquisitions of companies and additions to property and equipment. These impacts were partially offset by a $2.8 billion increase in net cash from combined investment purchases, sales, and maturities.

 

PAGE 3533


 Part II 

Item 7

 

Cash flow from operations for fiscal year 2004 decreased $1.17 billion to $14.63 billion. The decrease primarily reflects the combined cash outflows of $2.56 billion related to the Sun Microsystems settlement and the European Commission fine partially offset by increased cash receipts from customers driven by the rise in revenue billings. Cash used for financing was $2.36 billion in fiscal year 2004, a decrease of $2.86 billion from the previous year. The decrease reflects that we did not repurchase common stock in the fourth quarter of fiscal year 2004 combined with a $628 million increase primarily from stock issuances related to employee stock options exercises, partially offset by an $872 million increase in cash dividends paid. We repurchased 123.7 million shares of common stock under our share repurchase program in fiscal year 2004. Cash used for investing was $3.34 billion in fiscal year 2004, a decrease of $3.88 billion from fiscal year 2003.

We have no material long-term debt. Stockholders’ equity at June 30, 2006,2008, was $40.10$36.3 billion. We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology. Additions to property and equipment will continue, including new facilities, data centers, and computer systems for research and development, sales and marketing, support, and administrative staff. Commitments for constructing new buildings were $234 million$1.2 billion on June 30, 2006.2008. We have operating leases for most U.S. and international sales and support offices and certain equipment under which we incurred rental expense totaling $276$398 million, $299$325 million, and $331$271 million in fiscal yearyears 2008, 2007, and 2006, 2005 and 2004, respectively. We have issued residual value guarantees in connection with various operating leases. These guarantees provide that if we do not purchase the leased property from the lessor at the end of the lease term, then we are liable to the lessor for an amount equal to the shortage (if any) between the proceeds from the sale of the property and an agreed value. As of June 30, 2006, the maximum amount of the residual value guarantees was approximately $271 million. We believe that proceeds from the sale of properties under operating leases would exceed the payment obligation and therefore no liability currently exists. 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 requirements for capital resources.

InDuring fiscal year 2006,years 2008 and 2007, our Board of Directors declared $0.35 per share cash dividends, with $2.69 billion paid as of June 30, 2006. A quarterly dividend of $0.09 per share (or $906 million) was declared by our Board of Directors on June 21, 2006 to be paid to shareholders of record as of August 17, 2006, on September 14, 2006.the following dividends:

Declaration Date  Dividend Per Share  Record Date  Total Amount  Payment Date
         (in millions)   
(Fiscal year 2008)            

September 12, 2007

  $0.11  November 15, 2007  $1,034  December 13, 2007

December 19, 2007

  $0.11  February 21, 2008  $1,023  March 13, 2008

March 17, 2008

  $0.11  May 15, 2008  $1,020  June 12, 2008

June 11, 2008

  $0.11  August 21, 2008  $1,007  September 11, 2008
(Fiscal year 2007)            

September 13, 2006

  $0.10  November 16, 2006  $980  December 14, 2006

December 20, 2006

  $0.10  February 15, 2007  $978  March 8, 2007

March 26, 2007

  $0.10  May 17, 2007  $952  June 14, 2007

June 27, 2007

  $0.10  August 16, 2007  $938  September 13, 2007

On July 20, 2006, we announced the completion of the repurchase program initially approved by our Board of Directors on July 20, 2004 to buy back up to $30$30.0 billion in Microsoft common stock. The repurchases were made using our cash resources. During fiscal year 2006, we repurchased 754 million shares, or $19.75$19.8 billion, of our common stock under this plan. On July 20, 2006, we also announced that our Board of Directors authorized two new share repurchase programs, comprised ofprograms: a $20$20.0 billion tender offer, which was completed on August 17, 2006,2006; and authorization for up to an additional $20$20.0 billion ongoing share repurchase program with an expiration of June 30, 2011. Under the tender offer, we repurchased approximately 155 million shares of our common stock, or approximately 1.5% of theour common shares outstanding, for approximately $3.8 billion at a price per share of $24.75. On August 18, 2006, we announced that the authorization for the $20.0 billion ongoing share repurchase program previously announced on July 20, 2006, had been increased by approximately $16.2 billion. As a result, the company iswe were authorized to repurchase additional shares in an amount up to $36.2 billion through June 30, 2011. As of June 30, 2008, approximately $2.7 billion remained of the $36.2 billion approved repurchase amount.

We believe existing cash, cash equivalents, and short-term investments, together with funds generated from operations, should be sufficient to meet operating requirements, regular quarterly dividends, and planned share repurchases. Our philosophy regarding the maintenance of a balance sheet with a large component of cash and short-term investments, andas well as equity and other investments, reflects our views on potential future capital requirements relatingrelated to research and development, creation and expansion of sales distribution channels, investments and acquisitions, share dilution management, legal risks, and challenges to our business model. We regularly assess our investment management approach in view of our current and potential future needs.

Off-Balance Sheet Arrangements and Contractual Obligations

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 suchthese indemnifications under SFAS No. 5,Accounting for Contingencies, as interpreted by FASB Interpretation No. (“FIN”) 45,Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. We consider factors such as the degree of probability of an unfavorable outcome and the

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ability to make a reasonable estimate of the amount of loss. To date, we have not encountered material costs as a result of suchthese obligations and have not accrued any material liabilities related to suchthese indemnifications in our financial statements.

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Contractual Obligations

The following table summarizes our outstanding contractual obligations as of June 30, 2006:2008:

 

(In millions)(1)                                        
  Payments due by period  Payments due by period
Fiscal Years  2007  2008-2010  2011-2013  2014 and
thereafter
  Total  2009  2010-2012  2013-2015  2016 and
thereafter
  Total

Long-term debt

  $  $  $  $  $  $  $  $  $  $

Construction commitments(4)(2)

   234            234   1,226            1,226

Lease obligations:

                    

Capital leases

                     1         1

Operating leases(3)

   250   436   158   41   885   440   831   522   415   2,208

Purchase commitments(4)(2)

   2,219   9         2,228   2,520   5         2,525

Other long-term liabilities(5)(4)

   4   66   1      71   196   105         301
                         

Total contractual obligations(5)

  $2,707  $511  $159  $41  $3,418  $4,382  $942  $522  $415  $6,261
                              

 

(1) We have excluded the $970 million long-term contingent liability related to the antitrust and unfair competition class action lawsuits referred to in Note 17 – Contingencies of the Notes to Financial Statements as the timing and amount to be resolved in cash versus vouchers is subject to uncertainty.
(2)

We have certain commitments for the construction of buildings. We expect to fund these commitments with existing cash and cash flows from operations.

(2)

The amounts presented as purchase and construction commitments include all known open purchase orders and all known contracts that are take-or-pay contracts. We expect to fund these commitments with existing cash and cash flows from operations.

(3) 

Our future minimum rental commitments under noncancellable leases comprise the majority of the operating lease obligations presented above. We expect to fund these commitments with existing cash and cash flows from operations.

(4) The amount

We have excluded long-term tax contingencies and other tax liabilities of $3.8 billion and other long-term contingent liabilities of approximately $500 million (related to the antitrust and unfair competition class action lawsuits) from the amounts presented above as purchasethe amounts that will be settled in cash are not known. We have also excluded non-cash items of $77 million and construction commitments includes all known open purchase orders and all known contracts that are take-or-pay contracts. We expect to fund these commitments with existing cash and our cash flows from operations.unearned revenue of $1.9 billion.

(5) 

We have excluded other obligations$3.1 billion of $5.22 billioncurrent taxes payable from other long-term liabilities presented abovethe amounts presented. This amount was paid to the IRS during the first quarter of fiscal year 2009 as a result of our settlement related to the amount that will be settled in cash is not known. We have also excluded unearned revenue of $1.76 billion.2000-2003 examination.

RECENTLY ISSUED ACCOUNTING STANDARDS

In November 2005, the FASB issued Staff Position (“FSP”) FAS123(R)-3,Transition Election toRecently Adopted Accounting for the Tax Effects of Share-Based Payment Awards.PronouncementsThis FSP requires an entity to follow either the transition guidance for the additional-paid-in-capital pool as prescribed in SFAS No. 123(R),Share-Based Payment, or the alternative transition method as described in the FSP. An entity that adopts SFAS No. 123(R) using the modified prospective application may make a one-time election to adopt the transition method described in this FSP. An entity may take up to one year from the later of its initial adoption of SFAS No. 123(R) or the effective date of this FSP to evaluate its available transition alternatives and make its one-time election. We elected to adopt the transition method as described in the FSP as of

On July 1, 2005. This method change did not have an impact on our2007, we adopted FIN 48 which provides a financial statements.

In June 2006, the FASB issued FIN No. 48,Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109, which clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109,Accounting for Income Taxes.The interpretation prescribes astatement recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Under FIN No. 48, requires recognitionwe 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 satisfyhas a greater than 50% probability threshold.likelihood of being realized upon ultimate settlement. FIN No. 48 also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Upon adoption, we recognized a $395 million charge to our beginning retained deficit as a cumulative effect of a change in accounting in interim periods, disclosure, and transition. FIN No. 48 is effective for us beginningprinciple. See Note 11 – Income Taxes of the Notes to Financial Statements (Part II, Item 8).

On July 1, 2007. We are assessing the potential impact that the adoption of FIN No. 48 will have on our financial statements.

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In June 2006, the FASB ratified the2007, we adopted Emerging Issues Task Force (“EITF”) consensus on EITF Issue No. 06-2 (“EITF 06-2”),Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43. EITF Issue No. 06-2 requires companies to accrue the costs of compensated absences under a sabbatical or similar benefit arrangement over the requisite service period. EITF IssueUpon adoption, we recognized a $17 million charge to our beginning retained deficit as a cumulative effect of a change in accounting principle.

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Recent Accounting Pronouncements Not Yet Adopted

In March 2008, the FASB issued SFAS No. 06-2161,Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133,which requires additional disclosures about the objectives of the derivative instruments and hedging activities, the method of accounting for such instruments under SFAS No. 133 and its related interpretations, and a tabular disclosure of the effects of such instruments and related hedged items on our financial position, financial performance, and cash flows. SFAS No. 161 is effective for us beginning January 1, 2009. We are currently assessing the potential impact that adoption of SFAS No. 161 may have on our financial statements.

In December 2007, the FASB issued SFAS No. 141R,Business Combinations, which replaces SFAS No. 141. The statement retains the purchase method of accounting for acquisitions, but requires a number of changes, including changes in the way assets and liabilities are recognized in the purchase accounting. It also changes the recognition of assets acquired and liabilities assumed arising from contingencies, requires the capitalization of in-process research and development at fair value, and requires the expensing of acquisition-related costs as incurred. SFAS No. 141R is effective for us beginning July 1, 2007. The cumulative effect2009 and will apply prospectively to business combinations completed on or after that date.

In December 2007, the FASB issued SFAS No. 160,Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51, which changes the accounting and reporting for minority interests. Minority interests will be recharacterized as noncontrolling interests and will be reported as a component of equity separate from the parent’s equity, and purchases or sales of equity interests that do not result in a change in control will be accounted for as equity transactions. In addition, net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the applicationincome statement and, upon a loss of this consensus on prior period results shouldcontrol, the interest sold, as well as any interest retained, will be recorded at fair value with any gain or loss recognized through a cumulative-effect adjustment to retained earnings as ofin earnings. SFAS No. 160 is effective for us beginning July 1, 2009 and will apply prospectively, except for the beginning of the year of adoption. Elective retrospective application is also permitted.presentation and disclosure requirements, which will apply retrospectively. We are currently evaluatingassessing the potential impact that adoption of SFAS No. 160 may have on our financial statements.

In February 2007, the FASB issued SFAS No. 159,The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 gives us the irrevocable option to carry many financial assets and liabilities at fair values, with changes in fair value recognized in earnings. SFAS No. 159 is effective for us beginning July 1, 2008. We do not believe SFAS No. 159 will have a material impact on our financial statements.

In September 2006, the FASB issued SFAS No. 157,Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This statement does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. In February 2008, the FASB issued FASB Staff Position (“FSP”) 157-2,Effective Date of FASB Statement No. 157,which delays the effective date of SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). SFAS No. 157 is effective for us beginning July 1, 2008; FSP 157-2 delays the effective date for certain items to July 1, 2009. We do not believe SFAS No. 157 will have a material impact of this guidance and the method of adoption that will be used.on our financial statements.

APPLICATION OF CRITICAL ACCOUNTING POLICIES

Our financial statements and accompanying notes are prepared in accordance with U.S. GAAP. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies for us include revenue recognition, impairment of investment securities, impairment of goodwill, accounting for research and development costs, accounting for legal contingencies, accounting for income taxes, accounting for stock-based compensation, and accounting for stock-based compensation.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. CustomersFor some of our products, customers receive certain

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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, thebasis. The fair value of whichthese elements is recognized over the product’s estimated life cycle.cycle for the Windows XP and previous PC operating systems. For Windows Vista, there are no significant undelivered elements and accordingly, no license revenue is deferred for Windows Vista sales. Changes to the elements in a software arrangement, the ability to identify VSOE for those elements, the fair value of the respective elements, and changes to a product’s estimated life cycle could materially impact the amount of earned and unearned revenue. Judgment is also required to assess whether future releases of certain software represent new products or upgrades and enhancements to existing products.

SFAS No. 115,Accounting for Certain Investments in Debt and Equity Securities, and SEC SAB 59,Staff Accounting Bulletin Topic 5M,Accounting for Noncurrent Marketable Equity Securities, provide guidance on determining when an investment is other-than-temporarily impaired. Investments are reviewed quarterly for indicators of other-than-temporary impairment. This determination requires significant judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, and our intent and ability to hold the investment. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments.

SFAS No. 142,Goodwill and Other Intangible Assets, requires that goodwill be tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (July 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition or sale or disposition of a significant portion of a reporting unit. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated using a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, the useful life over which cash flows will occur, and determination of our weighted average cost of capital. Changes in these estimates and assumptions could materially affect the determination of fair value and/orand 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.

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We account for research and development costs in accordance with severalapplicable accounting pronouncements, including SFAS No. 2,Accounting for Research and Development Costs, and SFAS No. 86,Accounting for the Costs ofComputer 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. Costs incurred after technological feasibility is established have not been material, and accordingly, we have expensed all research and development costs when incurred.

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 results of operations.cash flows.

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SFAS No. 109,Accounting for Income Taxes, establishes financial accounting and reporting standards for the effect of income taxes. The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Accruals for uncertain tax positions are provided for in accordance with the requirements of FIN 48. Under FIN 48, we may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. FIN 48 also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our financial position, results of operations, or cash flows. Accruals for tax contingencies are provided for in accordance with the requirements of SFAS No. 5.

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 vestingrequisite 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.

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Statement of Management’s Responsibility for Financial Statements

Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. The consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America.

The Company designs and maintains accounting and internal control systems to provide reasonable assurance at reasonable cost that assets are safeguarded against loss from unauthorized use or disposition, and that the financial records are reliable for preparing financial statements and maintaining accountability for assets. These systems are augmented by written policies, an organizational structure providing division of responsibilities, careful selection and training of qualified personnel, and a program of internal audits.

The Company engaged Deloitte & Touche LLP, an independent auditors,registered public accounting firm, to audit and render an opinion on the consolidated financial statements and management’s report on its assessment and the effectiveness of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States).

The Board of Directors, through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, internal auditors, and our independent auditorsregistered public accounting firm to ensure that each is meeting its responsibilities and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal auditors each have full and free access to the Audit Committee.

Steven A. Ballmer

Chief Executive Officer

Christopher P. Liddell

Senior Vice President, Finance and Administration; Chief Financial Officer

Frank H. Brod

Corporate Vice President, Finance and Administration; Chief Accounting Officer

 

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Item 7A

ITEM 7A.     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 financial position.cash flows. We hedge a portion of anticipated revenue and accounts receivable exposure to foreign currency fluctuations, primarily with option 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 generally not hedged. However, we use optionsput-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, in exchange for the premium received for the sold call.strike. We also hold equity securities for general investment return purposes. We have incurred material impairment charges related to these securities in previous periods.

At the beginning of the second fiscal quarter of fiscal year 2006, we changed the methodology we use to calculate VaR. We previously used a Monte Carlo simulation-based methodology to calculate VaR. In the second quarter of fiscal year 2006, we adopted a factor-based parametric methodology. The factor-based parametric methodology can be performed more frequently (resulting in more timely data), divides the aggregated VaR into its component risk factor groups, and is incrementally more accurate than the previously used simulation-based methodology in evaluating diversification effects of commodity risk factors and interactions between equity and currency factors. While we believe the efficiencies gained by changing to the parametric methodology are significant, we do not believe this methodology produces results that are significantly different from the simulation-based methodology.

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.

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The following table sets forth the one-day VaR for substantially all of our positions as of June 30, 2006 and 2005, and for the fiscal yearyears ended June 30, 2006:2008 and 2007:

 

(In millions)                                        
        Year ended June 30, 2006        Year ended June 30, 2008
Risk Categories  2006  2005  Average  High  Low  June 30, 2008  June 30, 2007  Average  High  Low

Interest rates

  $66  $88  $82  $127  $62  $34  $34  $32  $37  $25

Currency rates

   91   52   33   91   11   100   55   93   145   60

Equity prices

   88   164   116   168   84   45   60   54   60   44

Commodity prices

   12   14   15   18   12   7   7   6   7   4
                         

Total one-day VaR for the combined risk categories was $158$123 million at June 30, 20062008 and $195$95 million at June 30, 2005.2007. The total VaR is 38%34% less at June 30, 20062008, and 39% less at June 30, 20052007, than the sum of the separate risk categories in the above table due to the diversification benefit of the combination of risks.overall portfolio.

 

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Item 8

ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INCOME STATEMENTS

 

(In millions, except per share amounts)                        
Year Ended June 30  2006     2005     2004
Year Ended June 30,  2008  2007  2006

Revenue

  $44,282    $39,788    $36,835  $60,420  $51,122  $44,282

Operating expenses:

                

Cost of revenue

   7,650     6,031     6,596   11,598   10,693   7,650

Research and development

   6,584     6,097     7,735   8,164   7,121   6,584

Sales and marketing

   9,818     8,563     8,195   13,039   11,455   9,818

General and administrative

   3,758     4,536     5,275   5,127   3,329   3,758
                 

Total operating expenses

   27,810     25,227     27,801   37,928   32,598   27,810
                 

Operating income

   16,472     14,561     9,034   22,492   18,524   16,472

Investment income and other

   1,790     2,067     3,162   1,322   1,577   1,790
                 

Income before income taxes

   18,262     16,628     12,196   23,814   20,101   18,262

Provision for income taxes

   5,663     4,374     4,028   6,133   6,036   5,663
                 

Net income

  $12,599    $12,254    $8,168  $17,681  $14,065  $12,599
                      

Earnings per share:

                

Basic

  $1.21    $1.13    $0.76  $1.90  $1.44  $1.21
                      

Diluted

  $1.20    $1.12    $0.75  $1.87  $1.42  $1.20
                      

Weighted average shares outstanding:

                

Basic

   10,438     10,839     10,803   9,328   9,742   10,438

Diluted

   10,531     10,906     10,894   9,470   9,886   10,531

Cash dividends declared per common share

  $0.35    $3.40    $0.16  $0.44  $0.40  $0.35

See accompanying notes.

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Item 8

BALANCE SHEETS

(In millions)         
June 30,  2008  2007 

Assets

   

Current assets:

   

Cash and cash equivalents

  $10,339  $6,111 

Short-term investments (including securities pledged as collateral of $2,491 and $2,356)

   13,323   17,300 
      

Total cash, cash equivalents, and short-term investments

   23,662   23,411 

Accounts receivable, net of allowance for doubtful accounts of $153 and $117

   13,589   11,338 

Inventories

   985   1,127 

Deferred income taxes

   2,017   1,899 

Other

   2,989   2,393 
      

Total current assets

   43,242   40,168 

Property and equipment, net of accumulated depreciation of $6,302 and $5,016

   6,242   4,350 

Equity and other investments

   6,588   10,117 

Goodwill

   12,108   4,760 

Intangible assets, net

   1,973   878 

Deferred income taxes

   949   1,389 

Other long-term assets

   1,691   1,509 
      

Total assets

  $72,793  $63,171 
         

Liabilities and stockholders’ equity

   

Current liabilities:

   

Accounts payable

  $4,034  $3,247 

Accrued compensation

   2,934   2,325 

Income taxes

   3,248   1,040 

Short-term unearned revenue

   13,397   10,779 

Securities lending payable

   2,614   2,741 

Other

   3,659   3,622 
      

Total current liabilities

   29,886   23,754 

Long-term unearned revenue

   1,900   1,867 

Other long-term liabilities

   4,721   6,453 

Commitments and contingencies

   

Stockholders’ equity:

   

Common stock and paid-in capital – shares authorized 24,000; outstanding 9,151 and 9,380

   62,849   60,557 

Retained deficit, including accumulated other comprehensive income of $1,140 and $1,654

   (26,563)  (29,460)
      

Total stockholders’ equity

   36,286   31,097 
      

Total liabilities and stockholders’ equity

  $72,793  $63,171 
         

See accompanying notes.

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CASH FLOWS STATEMENTS

(In millions)              
Year Ended June 30,  2008  2007   2006 

Operations

     

Net income

  $17,681  $14,065   $12,599 

Depreciation, amortization, and other noncash items

   2,056   1,440    903 

Stock-based compensation

   1,479   1,550    1,715 

Net recognized gains on investments

   (572)  (292)   (270)

Excess tax benefits from stock-based payment arrangements

   (120)  (77)   (89)

Deferred income taxes

   935   421    219 

Unearned revenue

   24,532   21,032    16,453 

Recognition of unearned revenue

   (21,944)  (19,382)   (14,729)

Accounts receivable

   (1,569)  (1,764)   (2,071)

Other current assets

   153   232    (1,405)

Other long-term assets

   (98)  (435)   (49)

Other current liabilities

   (748)  (552)   (145)

Other long-term liabilities

   (173)  1,558    1,273 
           

Net cash from operations

   21,612   17,796    14,404 
           

Financing

     

Common stock issued

   3,494   6,782    2,101 

Common stock repurchased

   (12,533)  (27,575)   (19,207)

Common stock cash dividends

   (4,015)  (3,805)   (3,545)

Excess tax benefits from stock-based payment arrangements

   120   77    89 

Other

      (23)    
           

Net cash used in financing

   (12,934)  (24,544)   (20,562)
           

Investing

     

Additions to property and equipment

   (3,182)  (2,264)   (1,578)

Acquisition of companies, net of cash acquired

   (8,053)  (1,150)   (649)

Purchases of investments

   (20,954)  (36,308)   (51,117)

Maturities of investments

   2,597   4,736    3,877 

Sales of investments

   25,132   41,451    54,353 

Securities lending payable

   (127)  (376)   3,117 
           

Net cash from (used in) investing

   (4,587)  6,089    8,003 
           

Effect of exchange rates on cash and cash equivalents

   137   56    18 
           

Net change in cash and cash equivalents

   4,228   (603)   1,863 

Cash and cash equivalents, beginning of period

   6,111   6,714    4,851 
           

Cash and cash equivalents, end of period

  $10,339  $6,111   $6,714 
              

See accompanying notes.

 

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BALANCE SHEETS

 

(In millions)             
June 30  2006     2005 

Assets

     

Current assets:

     

Cash and equivalents

  $6,714    $4,851 

Short-term investments (including securities pledged as collateral of $3,065 and $-)

   27,447     32,900 
        

Total cash and short-term investments

   34,161     37,751 

Accounts receivable, net of allowance for doubtful accounts of $142 and $171

   9,316     7,180 

Inventories, net

   1,478     491 

Deferred income taxes

   1,940     1,701 

Other

   2,115     1,614 
        

Total current assets

   49,010     48,737 

Property and equipment, net

   3,044     2,346 

Equity and other investments

   9,232     11,004 

Goodwill

   3,866     3,309 

Intangible assets, net

   539     499 

Deferred income taxes

   2,611     3,621 

Other long-term assets

   1,295     1,299 
        

Total assets

  $69,597    $70,815 
           

Liabilities and stockholders’ equity

     

Current liabilities:

     

Accounts payable

  $2,909    $2,086 

Accrued compensation

   1,938     1,662 

Income taxes

   1,557     2,020 

Short-term unearned revenue

   9,138     7,502 

Securities lending payable

   3,117      

Other

   3,783     3,607 
        

Total current liabilities

   22,442     16,877 

Long-term unearned revenue

   1,764     1,665 

Other long-term liabilities

   5,287     4,158 

Commitments and contingencies

     

Stockholders’ equity:

     

Common stock and paid-in capital – shares authorized 24,000; outstanding 10,062 and 10,710

   59,005     60,413 

Retained earnings (deficit), including accumulated other comprehensive income of $1,229 and $1,426

   (18,901)    (12,298)
        

Total stockholders’ equity

   40,104     48,115 
        

Total liabilities and stockholders’ equity

  $69,597    $70,815 
           

STOCKHOLDERS’ EQUITY STATEMENTS

(In millions)              
Year Ended June 30,  2008  2007   2006 

Common stock and paid-in capital

     

Balance, beginning of period

  $60,557  $59,005   $60,413 

Common stock issued

   3,504   6,783    1,939 

Common stock repurchased

   (3,022)  (6,162)   (4,447)

Stock-based compensation expense

   1,479   1,550    1,715 

Stock option income tax benefits (deficiencies)

   253   (661)   (617)

Other, net

   78   42    2 
           

Balance, end of period

   62,849   60,557    59,005 
           

Retained earnings (deficit)

     

Balance, beginning of period

   (29,460)  (18,901)   (12,298)

Cumulative effect of a change in accounting principle – adoption of
FIN 48
(1)

   (395)       

Cumulative effect of a change in accounting principle – adoption of
EITF 06-2
(1)

   (17)       

Net income

   17,681   14,065    12,599 

Other comprehensive income:

     

Net unrealized gains on derivative instruments

   18   14    76 

Net unrealized gains (losses) on investments

   (653)  326    (282)

Translation adjustments and other

   121   85    9 
           

Comprehensive income

   17,167   14,490    12,402 

Common stock cash dividends

   (4,084)  (3,837)   (3,594)

Common stock repurchased

   (9,774)  (21,212)   (15,411)
           

Balance, end of period

   (26,563)  (29,460)   (18,901)
           

Total stockholders’ equity

  $36,286  $31,097   $40,104 
              

(1)

See Note 1 of Notes to Financial Statements.

See accompanying notes.

 

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CASH FLOWS STATEMENTS

(In millions)             
Year Ended June 30  2006  2005  2004 

Operations

    

Net income

  $12,599  $12,254  $8,168 

Depreciation, amortization, and other noncash items

   903   855   1,186 

Stock-based compensation

   1,715   2,448   5,734 

Net recognized gains on investments

   (270)  (527)  (1,296)

Stock option income tax benefits

      668   1,100 

Excess tax benefits from stock-based payment arrangements

   (89)      

Deferred income taxes

   219   (179)  (1,479)

Unearned revenue

   16,453   13,831   11,777 

Recognition of unearned revenue

   (14,729)  (12,919)  (12,527)

Accounts receivable

   (2,071)  (1,243)  (687)

Other current assets

   (1,405)  (245)  478 

Other long-term assets

   (49)  21   34 

Other current liabilities

   (145)  396   1,529 

Other long-term liabilities

   1,273   1,245   609 
          

Net cash from operations

   14,404   16,605   14,626 
          

Financing

    

Common stock issued

   2,101   3,109   2,748 

Common stock repurchased

   (19,207)  (8,057)  (3,383)

Common stock cash dividends

   (3,545)  (36,112)  (1,729)

Excess tax benefits from stock-based payment arrangements

   89       

Other

      (18)   
          

Net cash used in financing

   (20,562)  (41,078)  (2,364)
          

Investing

    

Additions to property and equipment

   (1,578)  (812)  (1,109)

Acquisition of companies, net of cash acquired

   (649)  (207)  (4)

Purchases of investments

   (51,117)  (68,045)  (95,005)

Maturities of investments

   3,877   29,153   5,561 

Sales of investments

   54,353   54,938   87,215 

Net proceeds from securities lending

   3,117       
          

Net cash from (used in) investing

   8,003   15,027   (3,342)
          

Net change in cash and equivalents

   1,845   (9,446)  8,920 

Effect of exchange rates on cash and equivalents

   18   (7)  27 

Cash and equivalents, beginning of period

   4,851   14,304   5,357 
          

Cash and equivalents, end of period

  $6,714  $4,851  $14,304 
             

See accompanying notes.

 

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STOCKHOLDERS’ EQUITY STATEMENTS

(In millions)             
Year Ended June 30  2006  2005  2004 

Common stock and paid-in capital

    

Balance, beginning of period

  $60,413  $56,396  $49,234 

Common stock issued

   1,939   3,223   2,815 

Common stock repurchased

   (4,447)  (1,737)  (416)

Stock-based compensation expense

   1,715   2,448   5,734 

Stock option income tax benefits/(deficiencies)

   (617)  89   (989)

Other, net

   2   (6)  18 
          

Balance, end of period

   59,005   60,413   56,396 
          

Retained earnings (deficit)

    

Balance, beginning of period

   (12,298)  18,429   15,678 

Net income

   12,599   12,254   8,168 

Other comprehensive income:

    

Net gains/(losses) on derivative instruments

   76   (58)  101 

Net unrealized investments gains/(losses)

   (282)  371   (873)

Translation adjustments and other

   9   (6)  51 
          

Comprehensive income

   12,402   12,561   7,447 

Common stock cash dividends

   (3,594)  (36,968)  (1,729)

Common stock repurchased

   (15,411)  (6,320)  (2,967)
          

Balance, end of period

   (18,901)  (12,298)  18,429 
          

Total stockholders’ equity

  $40,104  $48,115  $74,825 
             

See accompanying notes.

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NOTES TO FINANCIAL STATEMENTS

NOTE 1    ACCOUNTING POLICIES

ACCOUNTING PRINCIPLES

The financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America.

PRINCIPLES OF CONSOLIDATION

The financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments in which we exercise significant influence but do not 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.

ESTIMATES AND ASSUMPTIONS

Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples include estimates of loss contingencies, 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 fair 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.

We revised our expense classification policies during fiscal year 2006 which resulted in reclassifications of certain operating expenses. We have reclassified the prior period amounts to conform to the current year presentation. These reclassifications had no impact on total operating expenses, operating income and our net income.

FOREIGN CURRENCIES

Assets and liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Revenue and expenses are translated at average rates of exchange prevailing during the year. Translation adjustments resulting from this process are charged or credited to Other Comprehensive Income (“OCI”).

REVENUE RECOGNITION

Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is probable. We enter into certain arrangements where we are obligated to deliver multiple products and/or services (multiple elements). In these arrangements, we generally allocate the total revenue among the elements based on the sales price of each element when sold separately (vendor-specific objective evidence).

Revenue for retail packaged products, products licensed to original equipment manufacturers (“OEM”OEMs”), and perpetual licenses for current products under our Open and Select volume licensing programs generally is recognized as products are shipped, with ashipped. A portion of the revenue related to certain products, which include all Windows XP and previous PC operating systems, is recorded as unearned due to undelivered elements including, in some cases, free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis. The amount of revenue allocated to undelivered elements is based on the vendor-specific objective evidence of fair value for those elements using the residual method. Under the residual method, the total fair value of the undelivered elements, as indicated by vendor-specific objective evidence, is recorded as unearned, and the difference between the total arrangement fee and the amount recorded as unearned for the undelivered elements is recognized as revenue related to delivered elements. Unearned revenue due to undelivered elements is recognized ratably on a straight-line basis over the related product’s life cycle. Revenue related to Windows Vista is not subject to a similar deferral because there are no significant undelivered elements.

Revenue from multi-year licensing arrangements are accounted for as subscriptions, with billings recorded as unearned revenue and recognized as revenue ratably over the billing coverage period. Certain multi-year licensing

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arrangements include rights to receive future versions of software product on a when-and-if-available basis under Open and Select volume licensing programs (Software Assurance). In addition, other multi-year licensing

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arrangements include a perpetual license for current products combined with rights to receive future versions of software products on a when-and-if-available basis under Open, Select, and Enterprise Agreement volume licensing programs. Premier support services agreements, MSN Internet Access subscriptions, Xbox Live, and Microsoft Developer Network subscriptions are also accounted for as subscriptions.

Revenue related to our Xbox game console and other hardware components is recognized upon shipment of the product to retailers. Revenue related to games published by us is recognized when those games have been delivered to retailers. Revenue related to games published by third parties for use on the Xbox platform is recognized when games are manufactured forby the game publishers. Online advertising revenue is recognized as advertisements are displayed. Search advertising revenue is recognized when the ad appears in the search results or when the action necessary to earn the revenue has been completed. Consulting services revenue is recognized as services are rendered, generally based on the negotiated hourly rate in the consulting arrangement and the number of hours worked during the period. RevenueConsulting revenue for fixed pricefixed-price services arrangements is recognized based on percentageas services are provided.

Revenue generally is recognized net of completion.any taxes collected from customers and subsequently remitted to governmental authorities.

Costs related to insignificant obligations, which include telephoneincluding bug fixes and technical support, for developer tools software, PC games, computer hardware, and Xbox, are accrued when the related revenue is recognized. Provisions are recorded for estimated returns, concessions, warranties, and bad debts.

COST OF REVENUE

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 write-downs, 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.

RESEARCH AND DEVELOPMENT

Research and development expenses include payroll, employee benefits, stock-based compensation, and other headcount-related costsexpenses 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. We have determined that technological feasibility for our software products is reached shortly before the products are released to manufacturing. Costs incurred after technological feasibilityThe amortization of these costs is established have not been material, and accordingly, we have expensed all research and development costs when incurred.included in cost of revenue over the estimated lives of the products.

SALES AND MARKETING

Sales and marketing expenses include payroll, employee benefits, stock-based compensation, and other headcount-related costsexpenses associated with sales and marketing personnel, and the cost of advertising, promotions, tradeshows, seminars, and other marketing-related programs. Advertising costs are expensed as incurred. Advertising expense was $1.23$1.2 billion, $1.3 billion, and $1.2 billion in fiscal yearyears 2008, 2007, and 2006, $995 millionrespectively.

PRODUCT WARRANTY

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 fiscal year 2005,which we do business, but generally include parts and $904 millionlabor 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.

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STOCK-BASED COMPENSATION

We account for stock-based compensation in fiscal year 2004.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 applicable vesting period of the stock award (generally three to five years) using the straight-line method.

INCOME TAXES

Income tax expense includes U.S. and international income taxes, plus the provision for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently invested. Certain items of income and expense are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes.

FINANCIAL INSTRUMENTS

We consider all highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. The fair value of these investments approximates their carrying value. In general, investments with original maturities of greater than three months and remaining maturities of less than one year are classified as short termshort-term investments. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. All cash equivalents and short-term investments are classified as available for sale and are recorded at market value using the specific identification method; unrealized gains and lossesmethod. Changes in market value are reflected in OCI (excluding other-than-temporary impairments) are reflected in OCI..

Equity and other investments mayclassified as long-term include both debt and equity instruments. Debt securities and publicly traded equity securities are classified as available for sale and are recorded at market using the specific identification method. Unrealized gains and lossesChanges in market value are reflected in OCI (excluding other-than-temporary impairments) are reflected in OCI.. All other investments, excluding those accounted for using the equity method, are recorded at cost.

We lend certain fixed-income and equity securities to enhance investment income. The loaned securities continue to be carried as investments on our balance sheet. Collateral and/or security interest received is determined based upon the underlying security lent and the creditworthiness of the borrower. Cash collateral is recorded as an asset with a corresponding liability.

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Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary. We employ a systematic methodology on a quarterly basis that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, and our intent and ability to hold the investment. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded and a new cost basis in the investment is established.

We use derivative instruments to manage exposures to foreign currency, equity price, interest rate and credit risks, to enhance returns, and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Derivative instruments are recognized as either assets or liabilities and are measured at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. For a derivative instrument designated as a fair-value hedge, the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributed to the risk being hedged. For a derivative instrument designated as a cash-flow hedge, the effective portion of the derivative’s gain or loss is initially reported as a component of OCI and is subsequently recognized in earnings when the hedged exposure affects earnings. The ineffective portion of the gain or loss is recognized in earnings. For options designated either as fair-value or cash-flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. Gains and losses from changes in fair values of derivatives that are not designated as hedges for accounting purposes are recognized in earnings.

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Foreign Currency Risk.    Certain assets, liabilities, and forecasted transactions are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the overall effectiveness of our foreign currency hedge positions. Options are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash-flow hedging instruments under Statement of Financial Accounting Standards (“SFAS”) No. 133,Accounting for Derivative Instruments and Hedging Activities. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. Certain non-U.S. dollarsdollar denominated securities are hedged using foreign exchange forward contracts that are designated as fair-value hedging instruments under SFAS No. 133. Certain options and forwards not designated as hedging instruments under SFAS No. 133 are also used to hedge the impact of the variability in exchange rates on accounts receivable and collections denominated in certain foreign currencies and to manage other foreign currency exposures.

Equities Price Risk.    Equity investments are subject to market price risk. From time to time, we use and designate options to hedge fair values and cash flows on certain equity securities. We determine the security or forecasted sale thereof, selected for hedging by evaluating market conditions, up-front costs, and other relevant factors. Certain options, futures, and swap contracts, not designated as hedging instruments under SFAS No. 133, are also used to manage equity exposures.

Interest Rate Risk.    Fixed-income securities are subject to interest rate risk. The fixed-income portfolio is diversified and consists primarily of investment grade securities to minimize credit risk. We use exchange-traded option and futurefutures contracts and over-the-counter swap contracts, not designated as hedging instruments under SFAS No. 133, to hedge interest rate risk.

Other Derivatives.    Swap contracts, not designated as hedging instruments under SFAS No. 133, are used to manage exposures to credit risks, enhance returns, and to facilitate portfolio diversification. In addition, we may invest in warrants to purchase securities of other companies as a strategic investment. Warrants that can be net share settled are deemed derivative financial instruments and are not designated as hedging instruments. “To Be Announced” forward purchase commitments of mortgage-backed assets are also considered derivatives in cases where physical delivery of the assets areis not taken at the earliest available delivery date. All derivative instruments not designated as hedging instruments are recorded at fair value, with changes in value recognized in earnings during the period of change.

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ALLOWANCE FOR DOUBTFUL ACCOUNTS

The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience, and other currently available evidence. Activity in the allowance for doubtful accounts was as follows:

 

(In millions)                
Year Ended June 30  Balance at
beginning of period
  

Charged to costs

and expenses

  

Write-offs

and other

  

Balance at

end of period

2004

  $242  $44  $(120) $166

2005

   166   48   (43)  171

2006

   171   40   (69) $142
(In millions)  2008  2007   2006 
Year Ended June 30,           

Balance, beginning of period

  $117  $142   $171 

Charged to costs and expenses

   88   64    40 

Write-offs and other

   (52)  (89)   (69)
           

Balance, end of period

  $153  $117   $142 
              

INVENTORIES

Inventories are stated at the lower of cost or market, using the average cost method. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis.

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PROPERTY AND EQUIPMENT

Property and equipment is stated at cost and depreciated using the straight-line method over the shorter of the estimated life of the asset or the lease term, ranging from one to 15 years. Computer software developed or obtained for internal use is depreciated using the straight-line method over the estimated useful life of the software, generally three years or less.

GOODWILL

Goodwill is tested for impairment on an annual basis as of July 1, and between annual tests if indicators of potential impairment exist, using a fair-value-based approach. No impairment of goodwill has been identified during any of the periods presented.

INTANGIBLE ASSETS

Intangible assets are amortized using the straight-line method over their estimated period of benefit, ranging from one to ten years. We evaluate the recoverability of intangible assets periodically and take into account events or circumstances that warrant revised estimates of useful lives or that indicate that impairment exists. All of our intangible assets are subject to amortization. No material impairments of intangible assets have been identified during any of the periods presented.

RECENTLY ISSUED ACCOUNTING STANDARDS

Recently Adopted Accounting Pronouncements

On July 1, 2007, we adopted the provisions of Financial Accounting Standards Board (“FASB”) Interpretation No. 48 (“FIN 48”),Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109, which provides a financial statement recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. Under FIN 48, we may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. FIN 48 also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Upon adoption, we recognized a $395 million charge to our beginning retained deficit as a cumulative effect of a change in accounting principle. See Note 11 – Income Taxes.

On July 1, 2007, we adopted Emerging Issues Task Force Issue No. 06-2 (“EITF 06-2”),Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43. EITF 06-2 requires companies to accrue the costs of compensated absences under a sabbatical or similar benefit arrangement over the requisite service period. Upon adoption, we recognized a $17 million charge to our beginning retained deficit as a cumulative effect of a change in accounting principle.

Recent Accounting Pronouncements Not Yet Adopted

In March 2008, the FASB issued SFAS No. 161,Disclosures about Derivative Instruments and Hedging Activities, an amendment of FAS 133, which requires additional disclosures about the objectives of derivative instruments and hedging activities, the method of accounting for those instruments under SFAS No. 133 and its related interpretations, and a tabular disclosure of the effects of those instruments and related hedged items on our financial position, financial performance, and cash flows. SFAS No. 161 is effective for us beginning January 1, 2009. We are currently assessing the potential impact that adoption of SFAS No. 161 may have on our financial statements.

In December 2007, the FASB issued SFAS No. 141R,Business Combinations, which replaces SFAS No 141. The statement retains the purchase method of accounting for acquisitions, but requires a number of changes, including changes in the way assets and liabilities are recognized in the purchase accounting. It also changes the recognition of assets acquired and liabilities assumed arising from contingencies, requires the capitalization of in-process research and development at fair value, and requires the expensing of acquisition-related costs as incurred. SFAS No. 141R is effective for us beginning July 1, 2009 and will apply prospectively to business combinations completed on or after that date.

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NOTE 2    UNEARNED REVENUE Part II 

Unearned revenue is comprisedItem 8

In December 2007, the FASB issued SFAS No. 160,Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB 51, which changes the following items:

Volume licensing programs – Represents customer billingsaccounting and reporting for multi-year licensing arrangements, paid either upfrontminority 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 annually at the beginningsales of each billing coverage period, which areequity interests that do not result in a change in control will be accounted for as subscriptionsequity transactions. In addition, net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the income statement and, upon a loss of control, the interest sold, as well as any interest retained, will be recorded at fair value with revenueany gain or loss recognized ratably overin earnings. SFAS No. 160 is effective for us beginning July 1, 2009 and will apply prospectively, except for the billing coverage period.presentation and disclosure requirements, which will apply retrospectively. We are currently assessing the potential impact that adoption of SFAS No. 160 may have on our financial statements.

Undelivered elements – Represents free post-delivery telephone supportIn February 2007, the FASB issued SFAS No. 159,The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 gives us the rightirrevocable option to receive unspecified upgrades/enhancementscarry many financial assets and liabilities at fair value, with changes in fair value recognized in earnings. SFAS No. 159 is effective for us beginning July 1, 2008. We do not believe SFAS No. 159 will have a material impact on our financial statements.

In September 2006, the FASB issued SFAS No. 157,Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This statement does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of Microsoft Internet Explorerthe information. In February 2008, the FASB issued FASB Staff Position (“FSP”) 157-2,Effective Date of FASB Statement No. 157,which delays the effective date of SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a when-and-if-available basis. The amount recorded as unearnedrecurring basis (at least annually). SFAS No. 157 is basedeffective for us beginning July 1, 2008; FSP 157-2 delays the effective date for certain items to July 1, 2009. We do not believe SFAS No. 157 will have a material impact on our financial statements.

NOTE 2    EARNINGS PER SHARE

Basic earnings per share is computed on the sales price of those elements when sold separately and is recognized ratably on a straight-line basis over the related product’s life cycle. The percentage of revenue recorded as unearned due to undelivered elements ranges from approximately 15% to 25% of the sales price for Windows XP Home, approximately 5% to 15%weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed on the basis of the sales price for Windows XP Professional,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, stock awards, and approximately 1%shared performance stock awards. The components of basic and diluted earnings per share are as follows:

(In millions, except earnings per share)            
Year Ended June 30,  2008  2007  2006

Net income available for common shareholders (A)

  $17,681  $14,065  $12,599
         

Weighted average outstanding shares of common stock (B)

   9,328   9,742   10,438

Dilutive effect of employee stock options and awards

   142   144   93
         

Common stock and common stock equivalents (C)

   9,470   9,886   10,531
         

Earnings per share:

      

Basic (A/B)

  $1.90  $1.44  $1.21
         

Diluted (A/C)

  $1.87  $1.42  $1.20
            

For the years ended June 30, 2008, 2007 and 2006, 91 million, 199 million, and 649 million shares, respectively, were attributable to 15%outstanding stock options and were excluded from the calculation of diluted earnings per share because the sales price for desktop applications, depending on the terms and conditions of the license andexercise prices of the elements. Product life cycles are currently estimated at threestock options were greater than or equal to the average price of the common shares, and one-half yearstherefore their inclusion would have been anti-dilutive.

For the year ended June 30, 2007, four million shared performance stock awards, out of the 14 million targeted amount outstanding, were excluded from the calculation of the diluted earnings per share because the number of shares ultimately issued was contingent on our performance against metrics established for Windows operating systemsthe performance period, as discussed in Note 18 – Employee Stock and two years for desktop applications.Savings Plans.

 

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 Part II 

Item 8

 

Other – Represents payments for post-delivery support and consulting services to be performed in the future, online advertising for which the advertisement has yet to be displayed, Microsoft Business Solutions maintenance and enhancement billings, Xbox Live and other billings that are accounted for as subscriptions, and other agreements where Microsoft is committed to the delivery of future enhancements, products, or services, including the TV platform.

The components of unearned revenue were as follows:

 

(In millions)        
June 30  2006  2005

Volume licensing programs

  $7,661  $6,000

Undelivered elements

   2,066   2,119

Other

   1,175   1,048

Unearned revenue

  $10,902  $9,167
        

Unearned revenue by segment was as follows:

(In millions)        
June 30  2006  2005

Client

  $2,850  $2,687

Server and Tools

   3,792   3,048

Information Worker

   3,609   2,814

Other segments

   651   618

Unearned revenue

  $10,902  $9,167
        

NOTE 3    INVESTMENTS

The components of investments were as follows:

(In millions)  Cost basis  Unrealized
gains
  Unrealized
losses
  Recorded
basis
  Cash and
equivalents
  Short - term
investments
  

Equity

and other
investments

June 30, 2006                     

Cash

  $3,248  $  $  $3,248  $3,248  $  $

Mutual funds

   723   11   (1)  733   288   445   

Commercial paper

   3,242         3,242   3,150   92   

Certificates of deposit

   364         364      364   

U. S. Government and Agency securities

   4,904   4   (30)  4,878   14   4,790   74

Foreign government bonds

   6,034   21   (73)  5,982      5,982   

Mortgage backed securities

   4,285      (42)  4,243      4,243   

Corporate notes and bonds

   7,605   15   (18)  7,602      7,475   127

Municipal securities

   4,008   5   (45)  3,968   14   3,954   

Common stock and equivalents

   6,933   1,846   (34)  8,745         8,745

Preferred stock

   41   5      46         46

Other investments

   342         342      102   240
                         

Total

  $41,729  $1,907  $(243) $43,393  $6,714  $27,447  $9,232
                            

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Item 8

(In millions)  Cost basis  Unrealized
gains
  Unrealized
losses
   Recorded
basis
  Cash and
equivalents
  Short - term
investments
  

Equity

and other
investments

June 30, 2005                      

Cash

  $1,911  $  $   $1,911  $1,911  $  $

Mutual funds

   1,636   38       1,674   817   857   

Commercial paper

   1,566   4       1,570   1,570      

Certificates of deposit

   614          614   453   161   

U. S. Government and Agency securities

   9,943   29   (59)   9,913      9,913   

Foreign government bonds

   5,486   194   (2)   5,678      5,678   

Mortgage backed securities

   123          123      123   

Corporate notes and bonds

   8,053   50   (31)   8,072   80   7,473   519

Municipal securities

   8,579   70   (33)   8,616   20   8,596   

Common stock and equivalents

   7,273   1,970   (133)   9,110         9,110

Preferred stock

   1,067   4       1,071         1,071

Other investments

   403          403      99   304
                          

Total

  $46,654  $2,359  $(258)  $48,755  $4,851  $32,900  $11,004
                             

Investments with continuous unrealized losses for less than and greater than 12 months and their related fair values were as follows:

   Less than 12 months  12 months or greater  Total 
(In millions)  Fair value  Unrealized
losses
  Fair value  Unrealized
losses
  Fair value  Unrealized
losses
 
June 30, 2006                   

Mutual funds

  $14  $(1) $4  $  $18  $(1)

U. S. Government and Agency securities

   2,303   (24)  172   (6)  2,475   (30)

Foreign government bonds

   2,523   (56)  1,749   (17)  4,272   (73)

Mortgage backed securities

   2,692   (40)  102   (2)  2,794   (42)

Corporate notes and bonds

   4,721   (13)  359   (5)  5,080   (18)

Municipal securities

   1,323   (13)  1,192   (32)  2,515   (45)

Common stock and equivalents

   266   (33)  29   (1)  295   (34)
                      

Total

  $13,842  $(180) $3,607  $(63) $17,449  $(243)
   Less than 12 months  12 months or greater  Total 
(In millions)  Fair value  Unrealized
losses
  Fair value  Unrealized
losses
  Fair value  Unrealized
losses
 
June 30, 2005                   

U. S. Government and Agency securities

  $7,490  $(59) $  $   7,490  $(59)

Foreign government bonds

   32   (2)        32   (2)

Corporate notes and bonds

   4,536   (31)        4,536   (31)

Municipal securities

   4,339   (30)  239   (3)  4,578   (33)

Common stock and equivalents

   1,168   (111)  89   (22)  1,257   (133)
                      

Total

  $17,565  $(233) $328  $(25) $17,893  $(258)

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Item 8

At June 30, 2006 unrealized losses of $243 million consisted of: $196 million related to investment grade fixed-income securities, $12 million related to investments in high yield and emerging market fixed-income securities, $2 million related to domestic equity securities and $33 million related to international equity securities. Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic and international equities are due to market price movements. At June 30, 2005 unrealized losses of $258 million consisted of: $112 million related to investment grade fixed-income securities, $13 million related to investments in high yield and emerging market fixed income securities, $90 million related to domestic equity securities and $43 million related to international equity securities. Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic and international equities are due to market price movements. Management does not believe any unrealized losses represent an other-than-temporary impairment based on our evaluation of available evidence as of June 30, 2006.

Common and preferred stock and other investments that are restricted for more than one year or are not publicly traded are recorded at cost. At June 30, 2006 the recorded basis of these investments was $41 million, and their estimated fair value was $41 million. At June 30, 2005 the recorded basis of these investments was $1.05 billion, and their estimated fair value was $1.27 billion. The estimate of fair value is based on publicly available market information or other estimates determined by management.

The maturities of debt securities, including fixed maturity securities, at June 30, 2006 were as follows:

(In millions)  Cost basis  Estimated fair
value

Due in one year or less

  $5,680  $5,686

Due after one year through five years

   12,011   11,971

Due after five years through ten years

   6,111   6,041

Due after ten years

   6,741   6,683
     

Total

  $30,543  $30,381
        

NOTE 43    INVESTMENT INCOME AND OTHER

The components of investment income and other were as follows:

 

(In millions)             
Year Ended June 30  2006  2005  2004 

Dividends and interest

  $1,510  $1,460  $1,892 

Net gains on investments

   161   856   1,563 

Net losses on derivatives

   (99)  (262)  (268)

Income/(losses) from equity investees and other

   218   13   (25)
          

Investment income and other

  $1,790  $2,067  $3,162 
             
(In millions)              
Year Ended June 30,  2008  2007   2006 

Dividends and interest

  $888  $1,319   $1,510 

Net recognized gains on investments

   346   650    161 

Net gains (losses) on derivatives

   226   (358)   (99)

Other

   (138)  (34)   218 
           

Investment income and other

  $1,322  $1,577   $1,790 
              

Net gains on investments includeincluded other-than-temporary impairments of $312 million, $25 million, and $408 million in fiscal yearyears 2008, 2007, and 2006, $152 million in fiscal year 2005, and $82 million in fiscal year 2004. The increase in other-than-temporary impairments in fiscal year 2006 was driven by planned sales of certain investments in an unrealized loss position in order to raise funds for the $20 billion tender offer announced on July 20, 2006.respectively. Realized gains and (losses)losses from sales of available-for-sale securities (excluding other-than-temporary impairments) were $1.11 billion$751 million and $(531)$93 million, respectively, in fiscal year 2006, $1.38 billion2008, $851 million and $(376)$176 million, respectively, in fiscal year 2005,2007, and $2.16$1.1 billion and $(518)$531 million, respectively, in fiscal year 2004.2006.

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 Part II 

Item 8

NOTE 4    INVESTMENTS

The components of investments, including associated derivatives, were as follows:

(In millions)  Cost basis  Unrealized
gains
  Unrealized
losses
  Recorded
basis
  

Cash

and cash
equivalents

  Short-term
investments
   

Equity

and other
investments

June 30, 2008                      

Cash

  $3,274  $  $  $3,274  $3,274  $   $

Mutual funds

   1,044   15   (8)  1,051   835   136    80

Commercial paper

   787         787   787       

Certificates of deposit

   1,580         1,580   1,373   207    

U.S. Government and Agency securities

   4,200   37   (4)  4,233   1,839   2,318    76

Foreign government bonds

   3,466   15   (62)  3,419      3,419    

Mortgage-backed securities

   3,628   31   (25)  3,634      3,634    

Corporate notes and bonds

   5,013   91   (39)  5,065   2,122   2,943    

Municipal securities

   761   4   (4)  761   109   652    

Common stock and equivalents

   4,508   1,215   (113)  5,610          5,610

Preferred stock

   307   9      316          316

Other investments

   520         520      14    506
                          

Total

  $29,088  $1,417  $(255) $30,250  $10,339  $13,323   $6,588
                             
(In millions)  Cost basis  Unrealized
gains
  Unrealized
losses
  Recorded
basis
  

Cash

and cash
equivalents

  Short-term
investments
   

Equity

and other
investments

June 30, 2007                      

Cash

  $3,040  $  $  $3,040  $3,040  $   $

Mutual funds

   398   4   (1)  401   132   205    64

Commercial paper

   227         227   179   48    

Certificates of deposit

   98         98      98    

U.S. Government and Agency securities

   3,085   4   (12)  3,077   1   3,002    74

Foreign government bonds

   3,845   2   (63)  3,784      3,784    

Mortgage-backed securities

   3,236   4   (49)  3,191      3,191    

Corporate notes and bonds

   7,184   14   (18)  7,180   2,425   4,753    2

Municipal securities

   2,639   3   (25)  2,617   334   2,283    

Common stock and equivalents

   7,290   2,309   (18)  9,581          9,581

Preferred stock

   62   12      74          74

Other investments

   258         258      (64)   322
                          

Total

  $31,362  $2,352  $(186) $33,528  $6,111  $17,300   $10,117
                             

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 Part II 

Item 8

Investments with continuous unrealized losses for less than 12 months and 12 months or greater and their related fair values were as follows:

   Less than 12 months  12 months or greater  Total 
(In millions)  Fair value  unrealized
losses
  Fair value  unrealized
losses
  Total
fair value
  unrealized
losses
 
June 30, 2008                   

Mutual funds

  $123  $(7) $12  $(1) $135  $(8)

U.S. Government and Agency securities

   342   (4)        342   (4)

Foreign government bonds

   2,241   (62)        2,241   (62)

Mortgage-backed securities

   1,078   (25)        1,078   (25)

Corporate notes and bonds

   807   (26)  925   (13)  1,732   (39)

Municipal securities

   176   (3)  193   (1)  369   (4)

Common stock and equivalents

   598   (106)  28   (7)  626   (113)
                      

Total

  $5,365  $(233) $1,158  $(22) $6,523  $(255)
                         
   Less than 12 months  12 months or greater  Total 
(In millions)  Fair value  unrealized
losses
  Fair value  unrealized
losses
  Total
fair value
  unrealized
losses
 
June 30, 2007                   

Mutual funds

  $76  $(1) $3  $  $79  $(1)

U.S. Government and Agency securities

   1,219   (8)  238   (4)  1,457   (12)

Foreign government bonds

   3,554   (63)  2      3,556   (63)

Mortgage-backed securities

   2,520   (43)  214   (6)  2,734   (49)

Corporate notes and bonds

   526   (14)  74   (4)  600   (18)

Municipal securities

   575   (9)  420   (16)  995   (25)

Common stock and equivalents

   237   (17)  9   (1)  246   (18)
                      

Total

  $8,707  $(155) $960  $(31) $9,667  $(186)
                         

At June 30, 2008, unrealized losses of $255 million consisted of: $121 million related to investment grade fixed-income securities, $21 million related to investments in high yield and emerging market fixed-income securities, $99 million related to domestic equity securities, and $14 million related to international equity securities. At June 30, 2007, unrealized losses of $186 million consisted of: $161 million related to investment grade fixed-income securities, $7 million related to investments in high yield and emerging market fixed-income securities, $7 million related to domestic equity securities, and $11 million related to international equity securities. Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic and international equities are due to market price movements. Management does not believe any unrealized losses represent an other-than-temporary impairment based on our evaluation of available evidence as of June 30, 2008.

Common and preferred stock and other investments that are restricted for more than one year or are not publicly traded are recorded at cost. At June 30, 2008, the recorded basis and estimated fair value of these investments was $289 million. At June 30, 2007, the recorded basis and estimated fair value of these investments was $38 million. The estimate of fair value is based on publicly available market information or other estimates determined by management.

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 Part II 

Item 8

The maturities of debt securities, including fixed-maturity securities, at June 30, 2008, were as follows:

(In millions)        Cost basis ��Estimated fair
value

Due in one year or less

  $3,618  $3,618

Due after one year through five years

   3,805   3,858

Due after five years through ten years

   1,582   1,559

Due after ten years

   7,831   7,846
     

Total

  $16,836  $16,881
        

NOTE 5    DERIVATIVES

For derivative instruments designated as hedges, hedge ineffectiveness, determined in accordance with SFAS No. 133,Accounting for Derivative Instruments and Hedging Activities,, did not have a significant impact on earnings

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 Part II 

Item 8

for fiscal years 2006, 2005,2008, 2007, or 2004.2006. During fiscal year 2006, $2172008, $274 million in gains on fair valuefair-value hedges from changes in time value and $399$324 million in losses on cash flowcash-flow hedges from changes in time value were excluded from the assessment of hedge effectiveness and were included in investment income and other. During fiscal year 2005, $792007, $219 million in gains on fair valuefair-value hedges from changes in time value and $116$361 million in losses on cash flowcash-flow hedges from changes in time value were excluded from the assessment of hedge effectiveness and were included in investment income and other. During fiscal year 2004, $312006, $217 million in gains on fair valuefair-value hedges from changes in time value and $325$399 million in losses on cash flowcash-flow hedges from changes in time value were excluded from the assessment of hedge effectiveness and were included in investment income and other.

Derivative gains and losses included in OCI are reclassified into earnings at the time forecasted revenue or the sale of an equityunderlying investment is recognized. During fiscal year 2008, $104 million of derivative gains were reclassified to revenue. During fiscal year 2007, $168 million of derivative gains were reclassified to revenue. During fiscal year 2006, $166 million of derivative gains were reclassified to revenue and $23 million in derivative gains were reclassified to investment income and other. During fiscal year 2005, $57 million of derivative gains were reclassified to revenue and $33 million in derivative gains were reclassified to investment income and other. During fiscal year 2004, $14 million of derivative gains were reclassified to revenue and no derivative gains or losses were reclassified to investment income and other.

We estimate that $133$111 million of net derivative gains included in OCI will be reclassified into earnings within the next 12 months. No significant amounts of gains or losses were reclassified from OCI into earnings as a result of forecasted transactions that failed to occur for fiscal years 2006, 2005,2008, 2007, and 2004.2006.

Derivative fair values are based on quoted market prices or pricing models using current market data. The fair values of all derivative positions were as follows:

(In millions)  Short-term
investments(1)
  Other
current
assets
  Equity and
other
investments(1)
   Other
current
liabilities
  Other
long-term
liabilities
   Total 
June 30, 2008                     

Cash-flow hedges

  $  $488  $   $  $   $488 

Fair-value hedges

   (41)     767    (11)      715 

Other derivatives

   69   (34)  4    (20)      19 
                        

Total

  $28  $454  $771   $(31) $   $1,222 
                           
June 30, 2007                     

Cash-flow hedges

  $  $258  $   $  $   $258 

Fair-value hedges

   (11)     (29)   (340)  (22)   (402)

Other derivatives

   9   (20)  (6)   (114)      (131)
                        

Total

  $(2) $238  $(35)  $(454) $(22)  $(275)
                           

(1)

The amounts presented as short-term investments and equity and other investments were classified as investments in our balance sheets and were included in the amounts presented in Note 4 – Investments.

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NOTE 6    INVENTORIES

 

(In millions)                
June 30  2006  2005
June 30,  2008  2007

Raw materials

  $417  $435

Work in process

   31   148

Finished goods

  $1,013  $422   537   544

Raw materials and work in process

   465   69
       

Inventories

  $1,478  $491  $985  $1,127
            

NOTE 7    PROPERTY AND EQUIPMENT

 

(In millions)                
June 30  2006 2005 
June 30,  2008 2007 

Land

  $362  $313   $518  $428 

Buildings and improvements

   2,228   2,014    4,302   3,170 

Leasehold improvements

   918   851    1,728   1,077 

Computer equipment and software

   2,682   2,318    4,475   3,458 

Furniture and equipment

   1,033   879    1,521   1,233 
         

Property and equipment, at cost

   7,223   6,375    12,544   9,366 

Accumulated depreciation

   (4,179)  (4,029)   (6,302)  (5,016)
         

Property and equipment, net

  $3,044  $2,346   $6,242  $4,350 
              

Property and equipment are stated at cost. Depreciation is computed principally on the straight-line method over the estimated useful lives of the assets. The useful lives for buildings range from five to 15 years, leasehold improvements generally range from two to ten years – representing the applicable lease terms plus reasonably assured extensions, computer equipment and software range from two to three years, and furniture and equipment range from one to five years. Land is not depreciated.

During fiscal years 2006, 2005,2008, 2007, and 2004,2006, depreciation expense was $863 million, $723 million,$1.4 billion, $1.2 billion, and $647$863 million, respectively. The majority of depreciation expense in all years related to computer equipment.

NOTE 8    ACQUISITIONS

On August 10, 2007, we acquired all the outstanding shares of aQuantive, Inc. (“aQuantive”) for $5.9 billion, which was paid primarily in cash. Headquartered in Seattle, Washington, aQuantive is a digital marketing business that we expect will play a key role in the future development of our Online Services Business. We also believe the acquisition will help us build and support next-generation advertiser and publisher solutions in environments such as cross media planning, video-on-demand, and Internet protocol television. aQuantive was consolidated into our results of operations starting August 10, 2007, the acquisition date.

As a result of the aQuantive acquisition, we recorded $5.2 billion of goodwill in our Online Services Business. Of the $939 million of acquired intangible assets, $24 million was assigned to in-process research and development assets and was expensed. The remaining acquired intangible assets include $476 million of customer relationships with a weighted average life of six years, $327 million of technology-based intangible assets with a weighted average life of four years, and $112 million of other intangible assets with a weighted average life of five years.

On April 24, 2008, we acquired all the outstanding shares of Fast Search & Transfer ASA (“FAST”) for $1.3 billion, which was paid primarily in cash. Headquartered in Oslo, Norway, FAST is an enterprise search company that we expect will broaden our enterprise search technology product offerings to businesses and will enable innovation in related areas such as our portal and content management. FAST was consolidated into our results of operations starting April 24, 2008, the acquisition date.

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As a result of the FAST acquisition, we recorded $981 million of goodwill in our Microsoft Business Division. Of the $266 million of acquired intangible assets, $35 million was assigned to in-process research and development assets and was expensed. The remaining acquired intangible assets include $27 million of customer relationships with a weighted average life of seven years, $134 million of technology-based intangible assets with a weighted average life of five years, and $70 million of other intangible assets with a weighted average life of six years.

The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the dates of the aQuantive and FAST acquisitions:

(In millions)  aQuantive as of
August 10, 2007
  

FAST as of

April 24, 2008

Cash and cash equivalents

  $342  $91

Accounts receivable, net

   273   46

Other current assets

   6   7

Property, plant and equipment

   50   30

Intangible assets

   939   266

Goodwill

   5,189   981

Deferred income taxes

   179   

Other long-term assets

   7   5
     

Total assets acquired

  $6,985  $1,426

Accrued compensation

   37   39

Other current liabilities

   683   38

Deferred income taxes

   338   65

Other long-term liabilities

   70   10
     

Total liabilities assumed

  $1,128  $152
     

Net assets acquired

  $5,857  $1,274
        

In addition to aQuantive and FAST, we acquired 19 other entities during fiscal year 2008 for total consideration of $1.6 billion which was paid primarily in cash and included:

Danger, Inc. (“Danger”), a software-as-a-service company that provides mobile operators with an integrated end-to-end solution to deliver mobile data and Internet services to their subscribers. We acquired Danger for approximately $500 million in cash; and

18 other entities specializing in areas such as application security, desktop, and advertising solutions.

As a result of our acquisition of Danger and the 18 other entities, we recorded $1.2 billion of goodwill. In addition, $37 million was assigned to in-process research and development assets and was expensed. 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 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 Danger and the 18 other acquisitions, individually and in aggregate, were not material.

 

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NOTE 89    GOODWILL

Changes in the carrying amount of goodwill for fiscal years 20062008 and 20052007 by segment were as follows:

 

(In millions)                             
   Balance as
of June 30,
2004
  Acquisitions
/ purchase
accounting
adjustments
  Divestitures   Balance as
of June 30,
2005
  Acquisitions  Other  Balance as
of June 30,
2006

Client

  $37  $6  $   $43  $31  $  $74

Server and Tools

   106   135       241   29   (14)  256

Information Worker

   178   47       225   246      471

Microsoft Business Solutions

   2,207   3       2,210         2,210

MSN

   154   17       171   263   21   455

Mobile and Embedded Devices

   30          30      (24)  6

Home and Entertainment

   403      (14)   389   23   (18)  393
                          

Total

  $3,115  $208  $(14)  $3,309  $592  $(35) $3,866
                             
(In millions)                             
   Balance as
of June 30,
2008
  Acquisitions  Other  Balance as
of June 30,
2007
  Acquisitions  Other   Balance as
of June 30,
2006

Client

  $153  $77  $(1) $77  $6  $(3)  $74

Server and Tools

   738   90   68   580   325   (1)   256

Online Services Business

   6,274   5,775   (53)  552   123   (26)   455

Microsoft Business Division

   4,191   1,073   (14)  3,132   508   (57)   2,681

Entertainment and Devices Division

   752   354   (21)  419   21   (2)   400
                          

Total

  $12,108  $7,369  $(21) $4,760  $983  $(89)  $3,866
                             

We test goodwill for impairment annually during the first quarter of each fiscal yearon July 1 at the reporting unit level using a fair value approach, in accordance with the provisions of SFAS No. 142,Goodwill and Other Intangible Assets. Our annual testing resulted in no impairments of goodwill in fiscal years 20062008 and 2005.2007. 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, goodwill will be evaluated for impairment between annual tests.

DuringNone of the amount recorded as goodwill during fiscal year 2005, we had no material acquisitions. During the fiscal year 2006, we acquired the following entities for a total consideration of $689 million, which was primarily paid in cash:

Frontbridge Technologies, Inc., a California-based provider of managed services that addresses corporate e-mail compliance, security, and availability requirements;

Teleo, Inc., a California-based voice over Internet protocol software and services provider;

MediaStreams.com AG, a Zurich, Switzerland-based developer of PC-based voice over Internet protocol communication systems and peripheral equipment;

Lionhead Studios Ltd., a Guildford, England-based software studio specializing in PC game development;

Vexcel Corporation, a Colorado-based imagery technology and systems provider;

Massive Corporation, a New York-based developer of video game advertising;

ProClarity Corporation, an Idaho-based developer of advanced analysis and visualization technologies for business platforms; and

14 various other entities specializing in areas such as application security, digital access management, and networking solutions.

As a result of these acquisitions, we recorded $592 million of goodwill. None of that amount2008 is expected to be deductible for tax purposes. Goodwill was assignedThe purchase price allocation for acquisitions is preliminary for up to our operating segments12 months after the acquisition date and subject to revision as follows: $29 million to Server & Tools, $263 million to MSN, $31 million to Client, $246 million to Information Worker,more detailed analyses are completed and $23 million to Homeadditional information about fair value of assets and Entertainment. We also recorded $125 million of technology-based intangible assets with a weighted-average amortization period of 3.25 years, and $26 million of other intangible assets with a weighted-average amortization period of 4.5 years. Allliabilities become available. Any change in the fair value of the entities have been consolidated into our financial statements since their respective acquisition dates. Nonenet assets of the acquisitions, individually oracquired company will change the amount of the purchase price allocable to goodwill. Purchase price adjustments are included in “other” in the aggregate, are material to our consolidated results of operations. Accordingly, pro forma information has not been included.

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above table.

NOTE 910    INTANGIBLE ASSETS

The components of finite-lived intangible assets were as follows:

 

(In millions)                                                
June 30  2006  2005
June 30,  2008  2007
  Gross
carrying
amount
  Accumulated
amortization
 Net carrying
amount
  Gross
carrying
amount
  Accumulated
amortization
   Net carrying
amount
  Gross
carrying
amount
  Accumulated
amortization
 Net carrying
amount
  Gross
carrying
amount
  Accumulated
amortization
   Net carrying
amount

Contract-based

  $954  $(661) $292  $957  $(606)  $351  $1,074  $(796) $278  $988  $(727)  $261

Technology-based

   458   (255)  203   309   (200)   109   1,677   (672)  1,005   916   (407)   509

Marketing-related

   42   (32)  10   35   (25)   10   171   (65)  106   57   (39)   18

Customer-related

   54   (21)  33   40   (11)   29   708   (124)  584   122   (32)   90
                                 

Total

  $1,508  $(969) $539  $1,341  $(842)  $499  $3,630  $(1,657) $1,973  $2,083  $(1,205)  $878
                                      

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During fiscal year 20062008 and 2005,2007, we recorded additions to intangible assets of $189 million$1.6 billion and $90$473 million, respectively. We estimate that we have no significant residual value related to our intangible assets. The components of finite-lived intangible assets acquired during fiscal years 20062008 and 20052007 were as follows:

 

(In millions)                    
Year Ended June 30  2006  2005
Year Ended June 30,  2008  2007
  Amount  Weighted
average life
  Amount  Weighted
average life
  Amount  Weighted
average life
  Amount  Weighted
average life

Contract-based

  $36  4 years  $16  6 years  $91  6 years  $57  5 years

Technology-based

   140  4 years   64  5 years   787  4 years   333  4 years

Marketing-related

   5  3 years        116  5 years   14  4 years

Customer-related

   8  4 years   10  5 years   589  6 years   69  5 years
                   

Total

  $189    $90    $1,583    $473  
                    

Intangible asset additions included $694 million of technology-based intangible assets with a weighted-average life of four years, and $782 million of other intangible assets with a weighted-average life of six years, related to the acquisitions of aQuantive, FAST, Danger, and 18 other entities acquired. See Note 8 – Acquisitions.

Acquired intangibles generally are generally amortized on a straight-line basis over weighted average periods.lives. Intangible assets amortization expense was $472 million for fiscal year 2008, $236 million for fiscal year 2007, and $127 million for fiscal year 2006, $161 million for fiscal year 2005, and $170 million for fiscal year 2004.2006. The following table outlines the estimated future amortization expense related to intangible assets as of June 30, 2006 is as follows:2008:

 

(In millions)    
Year Ended June 30  Amount

2007

  $150

2008

   126

2009

   83

2010

   60

2011

   46

Total

  $465
    

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(In millions)    
Year Ended June 30,  Amount

2009

  $543

2010

   495

2011

   408

2012

   279

2013 and thereafter

   248
 

Total

  $1,973
    

NOTE 1011    INCOME TAXES

The components of the provision for income taxes were as follows:

 

(In millions)                          
Year Ended June 30  2006  2005   2004 
Year Ended June 30,  2008  2007  2006

Current taxes:

            

U.S. Federal

  $4,471  $3,401   $3,766   $4,357  $4,593  $4,471

U.S. State and Local

   101   152    174    256   154   101

International

   882   911    1,056    1,007   957   882
               

Current taxes

   5,454   4,464    4,996    5,620   5,704   5,454

Deferred taxes (benefits)

   209   (90)   (968)

Deferred taxes

   513   332   209
               

Provision for income taxes

  $5,663  $4,374   $4,028   $6,133  $6,036  $5,663
                    

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U.S. and international components of income before income taxes were as follows:

 

(In millions)                        
Year Ended June 30  2006  2005  2004
Year Ended June 30,  2008  2007  2006

U.S.

  $11,404  $9,806  $8,088  $12,682  $12,902  $11,404

International

   6,858   6,822   4,108   11,132   7,199   6,858
             

Income before income taxes

  $18,262  $16,628  $12,196  $23,814  $20,101  $18,262
                  

The items accounting for the difference between income taxes computed at the federal statutory rate and the provision for income taxes were as follows:

 

          
Year Ended June 30  2006 2005 2004 
Year Ended June 30,  2008 2007 2006 

Federal statutory rate

  35.0% 35.0% 35.0%  35.0% 35.0% 35.0%

Effect of:

        

Foreign earnings taxed at lower rates

  (4.6)% (3.1)% (1.7)%  (7.0)% (5.1)% (4.6)%

Examination settlements

  (0.6)% (4.7)%    (5.8)%   (0.6)%

European Commission fine

  2.1%   0.7%

Other reconciling items

  1.2% (0.9)% (0.3)%  1.5% 0.1% 0.5%
               

Effective rate

  31.0% 26.3% 33.0%  25.8% 30.0% 31.0%
                    

The 2006In general, other reconciling items includesconsist of interest, U.S. state income taxes, domestic production deductions, and research credits. In fiscal years 2008 and 2006, there were no individually significant other reconciling items. Other reconciling items in fiscal year 2007 included the impact of the $351a $195 million non-deductible European Commission fine. reduction resulting from various changes in tax positions taken in prior periods, related primarily to favorable developments in an IRS position and multiple foreign audit assessments.

The 2005 other reconciling items include a $179 million repatriation tax benefit under the American Jobs Creation Act of 2004. The 2004 other reconciling items include the $208 million benefit from the resolution of an issue remanded by the Ninth Circuit Court of Appeals and the impactcomponents of the $605 million non-deductible European Commission fine.deferred income tax assets and liabilities were as follows:

(In millions)         
June 30,  2008  2007 

Deferred income tax assets:

   

Stock-based compensation expense

  $2,225  $2,859 

Other expense items

   1,933   1,735 

Unearned revenue

   928   842 

Impaired investments

   331   710 

Other revenue items

   91   58 
      

Deferred income tax assets

  $5,508  $6,204 
      

Deferred income tax liabilities:

   

International earnings

  $(1,300) $(1,763)

Unrealized gain on investments

   (513)  (926)

Other

   (729)  (227)
      

Deferred income tax liabilities

   (2,542)  (2,916)
      

Net deferred income tax assets

  $2,966  $3,288 
         

Reported as:

   

Current deferred income tax assets

  $2,017  $1,899 

Long-term deferred income tax assets

   949   1,389 
      

Net deferred income tax assets

  $2,966  $3,288 
         

 

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The components of the deferred tax assets and liabilities were as follows:

 

(In millions)     
June 30  2006  2005 

Deferred income tax assets:

   

Stock-based compensation expense

  $3,630  $3,994 

Other expense items

   1,451   1,751 

Unearned revenue

   1,028   915 

Impaired investments

   989   861 

Other revenue items

   102   213 

Other

      173 
      

Deferred income tax assets

  $7,200  $7,907 
      

Deferred income tax liabilities:

   

International earnings

  $(1,715) $(1,393)

Unrealized gain on investments

   (801) $(1,169)

Other

   (133)  (23)
      

Deferred income tax liabilities

   (2,649)  (2,585)
      

Net deferred income tax assets

  $4,551  $5,322 
         

Reported as:

   

Current deferred tax assets

  $1,940  $1,701 

Long-term deferred tax assets

   2,611   3,621 
      

Net deferred income tax assets

  $4,551  $5,322 
         

Deferred income tax balances reflect the effects of temporary differences between the carrying amounts of assets and liabilities and their tax bases and are stated at enacted tax rates expected to be in effect when taxes are actually paid or recovered.

We have not provided deferred U.S. income taxes or foreign withholding taxes on temporary differences of approximately $505 million$7.5 billion resulting from earnings for certain non-U.S. subsidiaries which are permanently reinvested outside the United States. The amount of unrecognized deferred tax liability associated with these temporary differences is approximately $151 million.

The American Jobs Creation Act of 2004 (the “Act”) was enacted in October 2004. The Act creates a temporary incentive for U.S. corporations to repatriate foreign subsidiary earnings by providing an elective 85% dividends received deduction for certain dividends from controlled foreign corporations. Under these provisions, we repatriated approximately $780 million in dividends subject to the elective 85% dividends received deduction and we recorded a corresponding tax provision benefit of $179 million from the reversal of previously provided U.S. deferred tax liabilities on these unremitted foreign subsidiary earnings in 2005. The dividend was paid in June 2006.$2.2 billion.

Income taxes paid were $5.4 billion in fiscal year 2008, $5.2 billion in fiscal year 2007, and $4.8 billion in fiscal year 2006, $4.32006.

FIN 48

On July 1, 2007, we adopted the provisions of FIN 48 which had the following impact on our financial statements: increased current assets by $228 million, long-term assets by $1.1 billion, long-term liabilities by $2.1 billion, and retained deficit by $395 million; and decreased income taxes payable by $394 million. As of June 30, 2008, we had $3.2 billion of unrecognized tax benefits of which $2.3 billion, if recognized, would affect our effective tax rate. As of July 1, 2007, we had $7.1 billion of unrecognized tax benefits of which $5.3 billion, if recognized, would affect our effective tax rate. Our policy is to include interest and penalties related to unrecognized tax benefits in income tax expense. Interest totaled $121 million in fiscal year 2005,2008. As of June 30, 2008 and $2.5 billionJuly 1, 2007, we had accrued interest related to uncertain tax positions of $324 million and $863 million, respectively, net of federal income tax benefits, on our balance sheets.

The aggregate changes in the balance of unrecognized tax benefits were as follows:

(In millions)     
Year Ended June 30,  2008 

Balance, beginning of year

  $7,076 

Decreases related to settlements

   (4,787)

Increases for tax positions related to the current year

   934 

Increases for tax positions related to prior years

   66 

Decreases for tax positions related to prior years

   (80)

Reductions due to lapsed statute of limitations

   (14)
  

Balance, end of year

  $3,195 
     

During fiscal year 2004.2008, we reached a settlement with the Internal Revenue Service (“IRS”) on its 2000-2003 examination. As a result, we reduced our unrecognized tax benefits by $4.8 billion and recognized a tax provision reduction of $1.2 billion. We are under audit by the IRS for the tax years 2004-2006. We do not believe it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months as we do not believe the examination will be concluded within the next 12 months. As a result of our settlement related to the 2000-2003 examination, we paid the IRS approximately $3.1 billion during the first quarter of fiscal year 2009.

Tax Contingencies.    We are subject to income taxestax in many jurisdictions outside the United States, and numerous foreign jurisdictions. Significant judgmentnone of which are individually material to our financial position, cash flows, or results of operations.

NOTE 12    UNEARNED REVENUE

Unearned revenue is required in determining our worldwide provision for income taxes and recording the related assets and liabilities. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. We are regularly under audit by tax authorities. Accruals for tax contingencies are provided for in accordance with the requirements of SFAS No. 5,Accounting for Contingencies.

Although we believe we have appropriate support for the positions taken on our tax returns, we have recorded a liability for our best estimatecomprised of the probable loss on certain of these positions,following items:

Volume licensing programs – Represents customer billings for multi-year licensing arrangements, paid either upfront or annually at the non-current portion of which is included in other long-term liabilities. We believe that our accruals for tax liabilities are adequate for all open years, based on our assessment of many factors including past experience and interpretations of tax law applied to the factsbeginning of each matter,billing coverage period, which matters result primarily from inter-company transfer pricing, restructuring of foreignare accounted for as subscriptions with revenue recognized ratably over the billing coverage period.

 

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operations, tax benefits

Undelivered elements – Represents free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis. This revenue deferral is applicable for Windows XP and prior versions shipped as retail packaged products, products licensed to OEMs, and perpetual licenses for current products under our Open and Select volume licensing programs. The amount recorded as unearned is based on the sales price of those elements when sold separately and is recognized ratably on a straight-line basis over the related product’s life cycle. The percentage of revenue recorded as unearned due to undelivered elements ranges from approximately 15% to 25% of the Foreign Sales Corporationsales price for Windows XP Home and Extra Territorial Income tax rules,approximately 5% to 15% of the amountsales price for Windows XP Professional, depending on the terms and conditions of researchthe license and experimentation tax credits claimed, state income taxes,prices of the elements. Product life cycles are currently estimated at three and certain other matters. Although we believe our recorded assetsone-half years for Windows operating systems.

Other – Represents payments for post-delivery support and liabilities are reasonable, tax regulations are subjectconsulting services to interpretation and tax litigation is inherently uncertain; therefore our assessments can involve both a series of complex judgments about future events and rely heavily on estimates and assumptions. Although we believe that the estimates and assumptions supporting our assessments are reasonable, the final determination of tax audit settlements and any related litigation could be materially different than that which is reflected in historical income tax provisions and recorded assets and liabilities. If we were to settle an audit or a matter under litigation, it could have a material effect on our income tax provision, net income, or cash flowsperformed in the period or periodsfuture, online advertising for which that determination is made. Duethe advertisement has yet to be displayed, Microsoft Dynamics business solutions products, Xbox Live subscriptions, Mediaroom, and other offerings for which we have been paid upfront and earn the complexity involvedrevenue when we are not able to estimateprovide the range of reasonably possible losses in excess of amounts recorded.service or software, or otherwise meet the revenue recognition criteria.

The Internal Revenue Service (“IRS”) has completed and closed its auditscomponents of our consolidated federal income tax returns through 1999. The IRS is currently conducting an audit of our consolidated federal income tax return for tax years 2000 through 2003.

NOTE 11    OTHER LONG-TERM LIABILITIESunearned revenue were as follows:

 

(In millions)        
June 30  2006  2005

Tax contingencies

  $4,194  $3,066

Legal contingencies

   1,022   961

Employee stock option transfer program

      48

Other

   71   83
     

Other long-term liabilities

  $5,287  $4,158
        
(In millions)        
June 30,  2008  2007

Volume licensing programs

  $12,232  $9,334

Undelivered elements

   1,396   1,839

Other

   1,669   1,473
     

Unearned revenue

  $15,297  $12,646
        

Unearned revenue by segment was as follows:

(In millions)        
June 30,  2008  2007

Client

  $2,738  $2,875

Server and Tools

   5,007   3,652

Microsoft Business Division

   7,101   5,771

Other segments

   451   348
     

Unearned revenue

  $15,297  $12,646
        

NOTE 12    STOCKHOLDERS’ EQUITY13    OTHER LONG-TERM LIABILITIES

Shares of common stock outstanding were as follows:

(In millions)        
June 30,  2008  2007

Tax contingencies and other tax liabilities

  $3,812  $5,071

Legal contingencies

   530   778

Product warranty

   278   487

Other

   101   117
     

Other long-term liabilities

  $4,721  $6,453
        

 

(In millions)             
Year Ended June 30  2006  2005  2004 

Balance, beginning of year

  10,710  10,862  10,771 

Issued

  106  160  215 

Repurchased

  (754) (312) (124)
        

Balance, end of year

  10,062  10,710  10,862 
          

On July 20, 2006, we announced the completion of the $30 billion Microsoft common stock repurchase program approved by our Board of Directors on July 20, 2004. The repurchases were made using our cash resources. Our Board of Directors had previously approved a program to repurchase shares of our common stock. Under these repurchase plans, we have made the following share repurchases:

(share amounts in millions, dollars in billions)
Fiscal year          2006(1)          2005(1)          2004
   Shares  Amount  Shares  Amount  Shares  Amount

First quarter

  114.1  $3.0  22.8  $0.6  43.3  $1.2

Second quarter

  283.1   7.7  23.6   0.7  30.5   0.8

Third quarter

  180.7   4.9  95.1   2.4  49.9   1.4

Fourth quarter

  175.6   4.1  170.7   4.3     
                   

Total

  753.5  $19.7  312.2  $8.0  123.7  $3.4
                     

(1)All amounts repurchased in fiscal year 2005 and in fiscal year 2006 were repurchased under the repurchase plan approved by our Board of Directors on July 20, 2004.

 

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In fiscal year 2006, our Board of Directors declared the following dividends:

 

Declaration Date  

Dividend

Per Share

  Date of Record  

Total Amount

(in millions)

  Payment Date

September 23, 2005

  $0.08  November 17, 2005  $846  December 8, 2005

December 14, 2005

  $0.09  February 17, 2006  $926  March 9, 2006

March 27, 2006

  $0.09  May 17, 2006  $916  June 8, 2006

June 21, 2006

  $0.09  August 17,2006  $906(1) September 14, 2006

(1)The dividend declared on June 21, 2006 will be paid after the filing date of this report on Form 10-K and was included in other current liabilities as of June 30, 2006.

In fiscal year 2005, our Board of Directors declared the following dividends:

Declaration Date  

Dividend

Per Share

  Date of Record  

Total Amount

(in millions)

  Payment Date

July 20, 2004

  $0.08  August 25, 2004  $870  September 14, 2004

July 20, 2004

  $3.00  November 17, 2004  $32,640  December 2, 2004

September 15, 2004

  $0.08  November 17, 2004  $871  December 2, 2004

December 8, 2004

  $0.08  February 17, 2005  $868  March 10, 2005

March 23, 2005

  $0.08  May 18, 2005  $860  June 9, 2005

June 15, 2005

  $0.08  August 17, 2005  $857(1) September 8, 2005

(1)The dividend declared on June 15, 2005 was included in other current liabilities as of June 30, 2005.

NOTE 13    OTHER COMPREHENSIVE INCOME14    COMMITMENTS AND GUARANTEES

We have committed $1.2 billion for constructing new buildings as of June 30, 2008.

We have operating leases for most U.S. and international sales and support offices and certain equipment. Rental expense for operating leases was $398 million, $325 million, and $271 million, in fiscal years 2008, 2007, and 2006, respectively. Future minimum rental commitments under noncancellable leases are as follows:

(In millions)    
Year Ended June 30,  Amount

2009

  $440

2010

   323

2011

   272

2012

   236

2013 and thereafter

   937
 
  $2,208
    

We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products. In addition, we also provide indemnification against credit risk in several geographical locations to our volume license resellers in case the resellers fail to collect from the end user. Due to the nature of the indemnification provided to our resellers, we cannot estimate the fair value, nor determine the total nominal amount, of the indemnification. We evaluate estimated losses for these indemnifications under SFAS No. 5,Accounting for Contingencies, as interpreted by FIN No. 45,Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others. We consider such factors as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered material costs as a result of these obligations and have not accrued any liabilities related to these indemnifications in our financial statements.

Product Warranty

In July 2007, we announced the expansion of our global Xbox 360 warranty coverage to three years from the date of purchase for a general hardware failure indicated by three flashing red lights. The activitybasic Xbox 360 console warranty remains in place with a warranty period of one year from the date of purchase in most geographies.

The changes in our aggregate product warranty liabilities, which are included in other comprehensive incomecurrent liabilities and related tax effectsother long term-liabilities on our balance sheets, were as follows:

 

(In millions)             
Year Ended June 30  2006  2005  2004 

Net gains/(losses) on derivative instruments:

    

Unrealized gains/(losses), net of tax effect of $(25) in 2006, $(63) in 2005, and $49 in 2004

  $(47) $(116) $92 

Reclassification adjustment for losses included in net income, net of tax effect of $66 in 2006, $31 in 2005, and $5 in 2004

   123   58   9 
          

Net gains/(losses) on derivative instruments

   76   (58)  101 
          

Net unrealized investment gains/(losses):

    

Unrealized holding losses, net of tax effect of $(199) in 2006, $(69) in 2005, and $(994) in 2004

   (369)  (128)  (1,846)

Reclassification adjustment for losses included in net income, net of tax effect of $47 in 2006, $269 in 2005, and $524 in 2004

   87   499   973 
          

Net unrealized investment gains/(losses)

   (282)  371   (873)
          

Translation adjustments and other

   9   (6)  51 
          

Other comprehensive income /(loss)

  $(197) $307  $(721)
             
(In millions)         
Year Ended June 30,  2008  2007 

Balance, beginning of year

  $850  $10 

Accruals for warranties issued

   365   974 

Adjustments to pre-existing warranties

   36   92 

Settlements of warranty claims

   (559)  (226)
      

Balance, end of year

  $692  $850 
         

Accruals for warranties issued during fiscal year 2007 included charges incurred as a result of the expansion of our Xbox 360 warranty coverage as discussed above.

 

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The components of accumulated other comprehensive income were as follows:

 

(In millions)            
Year Ended June 30  2006  2005  2004

Net gains on derivative instruments

  $103  $27  $85

Net unrealized investment gains

   1,062   1,344   973

Translation adjustments and other

   64   55   61

Accumulated other comprehensive income

  $1,229  $1,426  $1,119
            

NOTE 15    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 investigations 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 June 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 in Utah, now transferred with other cases to Maryland, 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. 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, remanding the case to that court for further proceedings.

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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 as 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 entered orders dismissing plaintiff’s claims on multiple grounds. Alcatel-Lucent appealed. 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 video and user interface patents. The jury concluded that Microsoft had infringed two 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 will appeal 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. 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.

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 all of the patents is set for January 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 are appealing that ruling to the U.S. Court of Appeals for the Federal Circuit.

In April 2007, the Multimedia Patent Trust filed a complaint against Microsoft, Dell, and Gateway in San Diego, California accusing the parties of infringing three video-related patents that originally belonged to Alcatel-Lucent. Alcatel-Lucent created the Multimedia Patent Trust prior to the companies’ merger and transferred the patents at issue to the trust. In June 2008, the plaintiff dismissed one of the patent claims.

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 June 30, 2008, we had accrued aggregate liabilities of approximately $600 million in other current liabilities and approximately $500 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

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estimate could be up to $2.2 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.

NOTE 14    EMPLOYEE STOCK AND SAVINGS PLANS16    STOCKHOLDERS’ EQUITY

Effective July 1, 2005, we adopted SFAS No. 123(R),Share-Based Payment,using the modified prospective application transition method. Because the fair value recognition provisionsShares of SFAS No. 123, Stock-Based Compensation, and SFAS No. 123(R) were materially consistent under our equity plans, the adoption of SFAS No. 123(R) did not have a significant impact on our financial position or our results of operations. Prior to our adoption of SFAS No. 123(R), benefits of tax deductions in excess of recognized compensation costs were reported as operating cash flows. SFAS No. 123(R) requires excess tax benefits be reported as a financing cash inflow rather than as a reduction of taxes paid.

The stock-based compensation and related income tax benefitscommon stock outstanding were as follows:

 

(In millions)  2006  2005  2004

Total stock-based compensation

  $1,715  $2,448  $5,734

Income tax benefits related to stock-based compensation

  $600  $857  $2,007
(In millions)              
Year Ended June 30,  2008  2007   2006 

Balance, beginning of year

  9,380  10,062   10,710 

Issued

  173  289   106 

Repurchased

  (402) (971)  (754)
         

Balance, end of year

  9,151  9,380   10,062 
           

Employee Stock Purchase Plan.    We have an employee stock purchase plan for all eligible employees. Compensation expense for the employee stock purchase plan is recognized in accordance with SFAS No. 123(R). The administrative committee under the plan approved a change to the common stock purchase discount and approved the elimination of the related look back period and a change to quarterly purchase periods that became effective July 1, 2004. As a result, beginning in fiscal year 2005, shares of our common stock may presently be purchased by employees at three-month intervals at 90% of the fair market value on the last day of each three-month period. Employees may purchase shares having a value not exceeding 15% of their gross compensation during an offering period. During fiscal year 2006 employees purchased 17.2 million shares at an average price of $23.02 per share. At June 30, 2006, 141.9 million shares were reserved for future issuance. During fiscal year 2005 employees purchased 16.4 million shares at average prices of $23.33 per share.

Under the plan in effect previous to fiscal year 2005, shares of our common stock could be purchased at six month intervals at 85% of the lower of the fair market value on the first or the last day of each six-month period. Employees could purchase shares having a value not exceeding 15% of their gross compensation during an offering period. During fiscal year 2004 employees purchased 16.7 million shares at average prices of $22.74 per share.

Savings Plan.    We have a savings plan in the United States that qualifies under Section 401(k) of the Internal Revenue Code, and a number of savings plans in international locations. Participating U.S. employees may contribute up to 50% of their pretax salary, but not more than statutory limits. We contribute fifty cents for each dollar a participant contributes in this plan, with a maximum contribution of 3% of a participant’s earnings. Matching contributions for all plans were $178 million, $154 million, and $141 million in fiscal years 2006, 2005, and 2004, respectively. Matching contributions are invested proportionate to each participant’s voluntary contributions in the investment options provided under the plan. Investment options in the U.S. plan include Microsoft common stock, but neither participant nor our matching contributions are required to be invested in Microsoft common stock.

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Stock Plans.    We have stock plans for directors and for officers, employees, consultants, and advisors. At June 30, 2006, an aggregate of 812 million shares were authorized for future grant under our stock plans, which cover stock options, stock awards, and shared performance stock awards. Awards that expire or are canceled without delivery of shares generally become available for issuance under the plans. The options transferred to JPMorgan Chase Bank (“JPMorgan”) (see below) in fiscal year 2004 have been removed from our plans; any options transferred to JPMorgan that expire without being exercised will not become available for grant under any of our plans.

On November 9, 2004, our shareholders approved amendments to the stock plans that allowed our Board of Directors to adjust eligible options, unvested stock awards, and shared performance stock awards to maintain their pre-dividend value after the $3.00 special dividend. Additional awards were granted for options, stock awards, and shared performance stock awards by the ratio of post- and pre-special dividend stock price as of the ex-dividend date. Strike prices for options were decreased by the same ratio. Stock-based compensation was not affected by this adjustment. As a result of this approval and payment of the $3.00 special dividend on December 2, 2004, an adjustment to the prices and number of shares of existing awards was made resulting in a total of 96 million options and 6.7 million stock awards being issued to adjust the outstanding awards. In addition, the target shared performance stock awards were increased by 3.5 million shares.

We issue new shares to satisfy stock option exercises. On July 20, 2006, we announced the completion of the repurchase program initially approved by our Board of Directors on July 20, 2004 to buy back up to $30$30.0 billion in Microsoft common stock.

Stock AwardsOn July 20, 2006, we also announced that our Board of Directors authorized two new share repurchase programs: a $20.0 billion tender offer, which was completed on August 17, 2006; and Shared Performance Stock Awards.    Stock awards are grants that entitleauthorization for up to an additional $20.0 billion ongoing share repurchase program with an expiration of June 30, 2011. Under the holder totender offer, we repurchased approximately 155 million shares of common stock, asor 1.5% of our common shares outstanding, for approximately $3.8 billion at a price per share of $24.75. On August 18, 2006, we announced that the award vests. Our stock awards generally vest overauthorization for the $20.0 billion ongoing share repurchase program had been increased by approximately $16.2 billion. As a five-year period.

Shared Performance Stock Awards (“SPSAs”) are a form of stock awardresult, we were authorized to repurchase additional shares in which the number of shares ultimately received depends on our business performance against specified performance targets. The performance period for SPSAs issued in fiscal years 2004, 2005, and 2006 was July 1, 2003an amount up to $36.2 billion through June 30, 2006 (January 1, 2004 through June 30, 2006 for certain executive officers). Following the end of the performance period, the Board of Directors determined that the number of shares of stock awards to be issued was 37.0 million, based on the actual performance against metrics established for the performance period. One-third of the awards will vest in the first quarter of fiscal year 2007. An additional one-third of the awards will vest over each of the following two years. Because the SPSAs covered a three-year period, SPSAs issued in fiscal year 2005 and 2006 were given only to newly hired and promoted employees eligible to receive SPSAs.

The Company will grant SPSAs for fiscal year 2007 with a performance period of July 1, 2006 through June 30, 2007. At the end of the performance period, the number of shares of stock subject to the award will be determined by multiplying the target award by a percentage ranging from 0% to 150%. The percentage will be determined based on performance against metrics for the performance period, as determined by the Compensation Committee of the Board of Directors in its sole discretion. An additional 15% of the total stock and stock awards will be available as additional awards to participants based on individual performance. One-quarter of the shares of stock subject to each award will vest following the end of the performance period, and an additional one-quarter of the shares will vest over each of the following three years.

We measure the fair value of SAs and SPSAs based upon the market price of the underlying common stock as of the date of grant, reduced by the present value of estimated future dividends. SAs and SPSAs are amortized over their applicable vesting period (generally five years) using the straight-line method. The fair value of each award grant is estimated on the date of grant using the following assumptions:

(In millions)    2006    2005    2004

Dividend per share

    $0.08 - $0.09    $0.08    $0.16

Interest rates range

    3.2% - 5.3%    1.3% - 4.3%    0.9% - 4.2%

The dividend per share amounts for fiscal year 2006 and fiscal year 2005 are quarterly dividend amounts. The dividend amount of $0.16 was the total dividend per share for fiscal year 2004.

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During fiscal year 2006, the following activity occurred under our existing plans:

    Shares
(in millions)
  Weighted
Average
Grant-Date
Fair Value

Stock awards:

   

Nonvested balance at July 1, 2005

  71.3  $23.92

Granted

  47.3   24.70

Vested

  (15.7)  23.85

Forfeited

  (4.8)  23.60
     

Nonvested balance at June 30, 2006

  98.1  $24.25
       

Shared performance stock awards:

   

Nonvested balance at July 1, 2005

  35.3  $23.54

Granted

  3.1   24.80

Vested

     

Forfeited

  (1.8)  24.92
     

Nonvested balance at June 30, 2006

  36.6  $23.57
       

2011. As of June 30, 2006, there were $1.692008, approximately $2.7 billion and $383 millionremained of total unrecognized compensation costs related to SAs and SPSAs, respectively. These costs are expected to be recognized over a weighted average period of 3.1 years and 2.2 years, respectively.

During the 12 months ended June 30, 2005 and June 30, 2004,$36.2 billion approved repurchase amount. Under these repurchase plans, we have made the following activity occurred under our plans:share repurchases:

 

(In millions, except fair values)  Fiscal Year
2005
  Fiscal Year
2004

Stock awards granted

   41.0   32.6

Weighted average grant-date fair value

  $24.03  $24.09

Shared performance stock awards granted

   3.7   31.7

Weighted average grant-date fair value

  $24.35  $23.62
(In millions)                        
Year Ended June 30,  2008(1)  2007(2)  2006(3)
   Shares  Amount  Shares  Amount  Shares  Amount

First quarter

  81  $2,348  285  $6,965  114  $3,029

Second quarter

  120   4,081  205   6,037  283   7,666

Third quarter

  30   1,020  238   6,744  181   4,879

Fourth quarter

  171   4,975  243   7,367  176   4,175
                   

Total

  402  $12,424  971  $27,113  754  $19,749
                     

Stock Options.    In fiscal year 2004, we began granting employees stock awards rather than stock options as part of our equity compensation plans. Since then, stock options issued to employees have been issued primarily in conjunction with business acquisitions. Nonqualified stock options were granted to our directors under our non-employee director stock plan. Nonqualified and incentive stock options were granted to our officers and employees under our employee stock plans. Options granted between 1995 and 2001 generally vest over four and one-half years and expire seven years from the date of grant, while certain options vest either over four and one-half years or over seven and one-half years and expire ten years from the date of grant. Options granted after 2001 vest over four and one-half years and expire ten years from the date of grant. Approximately 2.9 million stock options were granted in conjunction with business acquisitions during fiscal year 2006. No stock options were granted during the year ended June 30, 2005. In fiscal year 2004, approximately two million stock options were granted, nearly all of which were granted in conjunction with business acquisitions.

During fiscal year 2004, we completed an employee stock option transfer program whereby employees could elect to transfer all of their vested and unvested options with a strike price of $33.00 or higher to JPMorgan. The options transferred to JPMorgan were amended and restated upon transfer to contain terms and conditions typical of equity option transactions entered into between sophisticated financial counterparties at arm’s length using standard terms and definitions for equity derivatives. As a result of this program, we recorded additional stock-based compensation expense of $2.21 billion ($1.48 billion after-tax or $0.14 per diluted share) which was recorded in the second quarter of fiscal year 2004. As of June 30, 2006, 237 million options transferred to JPMorgan remained outstanding but are excluded from the table below. These options have strike prices ranging from $28.60 to $89.58 per share and have expiration dates extending through December
(1)

All amounts repurchased in fiscal year 2008 were repurchased under the repurchase plan approved by our Board of Directors on July 20, 2006.

(2)

Approximately 155 million shares of common stock for approximately $3.8 billion were repurchased under our tender offer in the first quarter of fiscal year 2007. All other amounts repurchased were repurchased under the repurchase plan approved by our Board of Directors on July 20, 2006.

(3)

All amounts repurchased in fiscal year 2006 were repurchased under the repurchase plan approved by our Board of Directors on July 20, 2004.

 

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Employee stock options outstanding

In fiscal year 2008, our Board of Directors declared the following dividends:

Declaration Date  Dividend
Per Share
  Record Date  Total Amount
(in millions)
  Payment Date

September 12, 2007

  $0.11  November 15, 2007  $1,034  December 13, 2007

December 19, 2007

  $0.11  February 21, 2008  $1,023  March 13, 2008

March 17, 2008

  $0.11  May 15, 2008  $1,020  June 12, 2008

June 11, 2008

  $0.11  August 21, 2008  $1,007(1) September 11, 2008

(1)

The dividend declared on June 11, 2008 will be paid after the filing date of this report on Form 10-K and was included in other current liabilities as of June 30, 2008.

In fiscal year 2007, our Board of Directors declared the following dividends:

Declaration Date  Dividend
Per Share
  Record Date  Total Amount
(in millions)
  Payment Date

September 13, 2006

  $0.10  November 16, 2006  $980  December 14, 2006

December 20, 2006

  $0.10  February 15, 2007  $978  March 8, 2007

March 26, 2007

  $0.10  May 17, 2007  $952  June 14, 2007

June 27, 2007

  $0.10  August 16, 2007  $938(1) September 13, 2007

(1)

The dividend declared on June 27, 2007 was included in other current liabilities as of June 30, 2007.

NOTE 17    OTHER COMPREHENSIVE INCOME

The activity in other comprehensive income and related income tax effects were as follows:

 

    Shares
(in millions)
   Weighted
Average
Exercise Price
  Weighted
Average
Remaining
Contractual
Term (years)
  

Aggregate
Intrinsic
Value

(in millions)

Balance, July 1, 2005

  864   $27.41    

Granted

  3    23.54    

Exercised

  (76)   20.59    

Canceled

  (33)   32.13    

Forfeited

  (8)   23.01    
          

Balance, June 30, 2006

  750   $27.92  4.16  $452

Exercisable, June 30, 2006

  673   $28.55  3.93  $343
(In millions)              
Year Ended June 30,  2008  2007   2006 

Net unrealized gains on derivative instruments:

     

Unrealized gains, net of tax effect of $46 in 2008, $66 in 2007, and $107 in 2006

  $86  $123   $199 

Reclassification adjustment for gains included in net income, net of tax effect of $(36) in 2008, $(59) in 2007, and $(66) in 2006

   (68)  (109)   (123)
           

Net unrealized gains on derivative instruments

   18   14    76 
           

Net unrealized gains (losses) on investments:

     

Unrealized gains (losses), net of tax effect of $(234) in 2008, $393 in 2007, and $(105) in 2006

   (435)  730    (195)

Reclassification adjustment for gains included in net income, net of tax effect of $(117) in 2008, $(217) in 2007, and $(47) in 2006

   (218)  (404)   (87)
           

Net unrealized gains (losses) on investments

   (653)  326    (282)
           

Translation adjustments and other

   121   85    9 
           

Other comprehensive income (loss)

  $(514) $425   $(197)
              

Included in the options outstanding balance are approximately five million options that were granted in conjunction with business acquisitions. While these options are included in the options outstanding balance, they are excluded from the weighted average exercise prices presented. These options have an exercise price range of $0 to $150.93 and a weighted average exercise price of $11.26.

As of June 30, 2006, there were $402 million of total unrecognized compensation costs related to stock options. These costs are expected to be recognized over a weighted average period of approximately one year.

During fiscal years 2006, 2005, and 2004 the following activity occurred under our plans:

(In millions)  2006  2005  2004

Total intrinsic value of stock options exercised

  $491  $940  $2,971

Total fair value of stock awards vested

   377   198   20

Cash received and income tax benefit from stock option exercises for fiscal year 2006 were $1.71 billion and $183 million, respectively.

NOTE 15    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, stock awards, and shared performance stock awards. The components of basic and diluted earnings per share areaccumulated other comprehensive income were as follows:

 

(In millions, except earnings per share)            
Year Ended June 30  2006  2005  2004

Net income available for common shareholders (A)

  $12,599  $12,254  $8,168
         

Weighted average outstanding shares of common stock (B)

   10,438   10,839   10,803

Dilutive effect of employee stock options and awards

   93   67   91
         

Common stock and common stock equivalents (C)

   10,531   10,906   10,894
         

Earnings per share:

      

Basic (A/B)

  $1.21  $1.13  $0.76
         

Diluted (A/C)

  $1.20  $1.12  $0.75
            
(In millions)            
Year Ended June 30,  2008  2007  2006

Net unrealized gains on derivative instruments

  $135  $117  $103

Net unrealized gains on investments

   735   1,388   1,062

Translation adjustments and other

   270   149   64
         

Accumulated other comprehensive income

  $1,140  $1,654  $1,229
            

 

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For the years ended June 30, 2006, 2005, and 2004, 649 million, 854 million, and 1.2 billion shares, respectively, were attributable to outstanding stock options and were excluded from the calculation of diluted earnings per share because the exercise prices of the stock options were greater than or equal to the average price of the common shares, and therefore their inclusion would have been anti-dilutive. For the year ended June 30, 2006, 1.2 million shared performance stock awards, out of the 36.6 million targeted amount outstanding, have been excluded from the calculation of diluted earnings per share because the number of shares ultimately issued is contingent on our performance against metrics established for the performance period, as discussed in Note 14 – Employee Stock and Savings Plans.

NOTE 16    COMMITMENTS18    EMPLOYEE STOCK AND GUARANTEESSAVINGS PLANS

Stock-based compensation and related income tax benefits were as follows:

(In millions)  2008  2007  2006

Total stock-based compensation

  $1,479  $1,550  $1,715

Income tax benefits related to stock-based compensation

  $518  $542  $600

Employee Stock Purchase Plan.We have operating leasesan employee stock purchase plan for most U.S. and international sales and support offices and certain equipment. Rentalall eligible employees. Compensation expense for operating leases was $276the employee stock purchase plan is recognized in accordance with SFAS No. 123(R). Shares of our common stock may be purchased by employees at three-month intervals at 90% of the fair market value on the last day of each three-month period. Employees may purchase shares having a value not exceeding 15% of their gross compensation during an offering period. Employees purchased the following shares:

(Shares In millions)  2008  2007  2006

Shares purchased

   18   17   17

Average price per share

  $26.78  $25.36  $23.02

At June 30, 2008, 107 million $299shares were reserved for future issuance.

Savings Plan.    We have a savings plan in the United States that qualifies under Section 401(k) of the Internal Revenue Code, and a number of savings plans in international locations. Participating U.S. employees may contribute up to 50% of their salary, but not more than statutory limits. We contribute fifty cents for each dollar a participant contributes in this plan, with a maximum contribution of 3% of a participant’s earnings. Matching contributions for all plans were $238 million, $218 million, and $331$178 million in fiscal years 2008, 2007, and 2006, respectively. Matching contributions are invested proportionate to each participant’s voluntary contributions in the investment options provided under the plan. Investment options in the U.S. plan include Microsoft common stock, but neither participant nor our matching contributions are required to be invested in Microsoft common stock.

Stock Plans.    We have stock plans for directors and for officers, employees, consultants, and advisors. At June 30, 2008, an aggregate of 786 million shares were authorized for future grant under our stock plans, which cover stock options, stock awards, and shared performance stock awards. Awards that expire or are canceled without delivery of shares generally become available for issuance under the plans. We issue new shares to satisfy stock option exercises.

Stock Awards and Shared Performance Stock Awards.    Stock awards (“SAs”) are grants that entitle the holder to shares of common stock as the award vests. Our SAs generally vest over a five-year period.

Shared performance stock awards (“SPSAs”) are a form of SA in which the number of shares ultimately received depends on our business performance against specified performance targets. The performance period for SPSAs issued in fiscal years 2004, 2005, and 2006 was July 1, 2003 through June 30, 2006 (January 1, 2004 respectively. Future minimum rental commitments under noncancellable leases are as follows:

(In millions)    
Year Ended June 30  Amount

2007

  $250

2008

   193

2009

   138

2010

   105

2011 and thereafter

   199
  $885
    

We have committed $234 millionthrough June 30, 2006 for constructing new buildings.

In connection with various operating leases, we issued residual value guarantees, which provide that if we do not purchase the leased property from the lessor atcertain executive officers). Following the end of the lease term, then we are liable toperformance period, the lessor for an amount equal to the shortage (if any) between the proceeds from the saleCompensation Committee of the property and an agreed value. AsBoard of June 30, 2006, the maximum amount of the residual value guarantees was approximately $271 million. We believeDirectors determined that proceeds from the sale of properties under operating leases would exceed the payment obligation and therefore no liability to us currently exists.

We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products. In addition, we also provide indemnification against credit risk in several geographical locations to our volume license resellers in case the resellers fail to collect from the end user. Due to the nature of the indemnification provided to our resellers, we cannot estimate the fair value, nor determine the total nominal amount of the indemnification. We evaluate estimated losses for such indemnifications under SFAS No. 5,Accounting for Contingencies, as interpreted by FIN No. 45,Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others. We consider such factors 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 liabilities related to such indemnifications in our financial statements.

Our product warranty accrual reflects management’s best estimate of our probable liability under its product warranties (primarily relating to the Xbox console). We determine the warranty accrual based on known product failures (if any), historical experience, and other currently available evidence. Our warranty accrual totals $10 million as of June 30, 2006. There has been no significant activity impacting the results of operations for any period presented.

NOTE 17    CONTINGENCIES

Government competition law matters.    On March 25, 2004, the European Commission issued a decision in its competition law investigation of us. The Commission concluded that we infringed European competition law by refusing to provide our competitors with licenses to certain protocol technology in the Windows server operating systems and by including streaming media playback functionality in Windows desktop operating systems. The Commission ordered us to make the relevant licenses to our technology available to our competitors and to develop

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and make available a version of the Windows desktop operating system that does not include specified software relating to media playback. The decision also imposed a fine of497 million, which resulted in a charge in the third quarter of fiscal year 2004 of497 million ($605 million). We filed an appeal of the decision to the Court of First Instance on June 6, 2004. On December 22, 2004, the Court ordered that we must comply with the decision pending review on appeal and we are taking steps to ensure we are in compliance. The hearing on the appeal occurred in April 2006. We continue to contest the conclusion that European competition law was infringed and will defend our position vigorously. In December 2005, the Commission issued a Statement of Objections that preliminarily concluded we were not in full compliance with the 2004 decree. In March 2006, the Commission conducted an oral hearing on the Statement of Objections and our response to the Statement. On July 12, 2006, the European Commission announced its determination that we had not complied with the technical documentation requirements of the 2004 Decision, and levied a fine of281 million ($351 million). We will appeal this fine to the Court of First Instance.

On December 7, 2005, the Korean Fair Trade Commission (“KFTC”) announced a ruling in its investigation of us, holding that we abused a market dominant position and engaged in unfair trade practices under the Korean Fair Trade Law by incorporating instant messaging and media player functionality into the Windows PC operating system, and streaming media technologies into the Windows server operating system. The KFTC also announced the imposition of remedies, including a fine of approximately $34 million. The KFTC issued its formal written ruling and corrective order on February 23, 2006. The KFTC held that our integration of Windows Media Player and Windows Messenger in Windows PC operating systems and integration of Windows Media Services in Windows server operating systems constituted an abuse of monopoly power and unlawful tying in violation of the Korean Fair Trade Act. Under the order, which became effective August 24, 2006, we can no longer distribute Windows in Korea as currently designed. We are required to develop and distribute in Korea versions of Windows XP and its successors that do not include Windows Media Player or Windows Messenger functionality. In addition, we also may distribute a second modified version of Windows that contains the removed functionality, provided the second version includes promotional links in the user interface that will enable consumers to link to and download a select group of competing media players and instant messengers. We have appealed the KFTC’s decision to the Seoul High Court. On May 22, 2006, the KFTC denied our motion for reconsideration of its ruling. As part of that decision, the KFTC dropped the element of its ruling that prohibited us from including Windows Media Player or Windows Messenger, or any feature with similar functionality, in any product other than the Windows client operating system for which we have a 50% or greater market share. On August 23, 2006, we announced the release to manufacture of the mandated versions of Windows XP Home Edition and Windows XP Professional Edition.

In other ongoing investigations, various foreign governments and several state Attorneys General have requested information from us concerning competition, privacy, and security issues.

Antitrust, and 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 and federal courts on behalf of variously defined classes of direct and indirect purchasers of our PC operating system and certain software applications products. The federal cases have been consolidated in the U.S. District Court for Maryland. These cases allege that we competed unfairly and unlawfully monopolized alleged markets for operating systems and certain software applications, and they seek to recover alleged overcharges for these products. To date, courts have dismissed all claims for damages in cases brought against us by indirect purchasers under federal law and in 18 states. Ten of those state court decisions have been affirmed on appeal. There was no appeal in five states. In addition, courts in two states refused to certify classes, essentially bringing the litigation to a close. Claims under federal law brought on behalf of foreign purchasers have been dismissed by the U.S. District Court in Maryland as have all claims brought on behalf of consumers seeking injunctive relief under federal law. The ruling on injunctive relief and the ruling dismissing the federal claims of indirect purchasers were appealed to the United States Court of Appeals for the Fourth Circuit, together with a ruling denying certification of certain proposed classes of U.S. direct purchasers. On April 18, 2006, the Court of Appeals affirmed the trial court decision dismissing the indirect purchaser claims. Courts in 18 states have ruled that indirect purchaser cases may proceed as class actions. In 2003, we reached an agreement with counsel for the California plaintiffs to settle all claims in 27 consolidated cases in that state. Under the settlement, class members will be able to obtain vouchers that entitle the class members to be reimbursed up to the face value of their vouchers for purchases of a wide variety of platform-neutral computer hardware and software. The total value of vouchers issued will depend on the number of class members who make a claim and are issued vouchers. Two-thirdsshares of the value of vouchers unissued or unredeemed by class members will be made available to certain

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schools in California in the form of vouchers that also may be redeemed for cash against purchases of a wide variety of platform-neutral computer hardware, software, and related services. We also have reached similar agreements to settle all claims in a number of other states. The settlements in these states are structured similarly to the California settlement, except that, among other differences, one-half of the value of vouchers unissued to class members will be made available to certain schools in the relevant states. The maximum value of vouchersSAs to be issued was 37 million, based on the actual performance against metrics established for the performance period. One-third of the awards vested in these settlements, includingeach of the California settlement, is approximately $2.5 billion. fiscal years 2007 and 2008. An additional one-third of the awards will vest in fiscal year 2009. Because the SPSAs covered a three-year period, SPSAs issued in fiscal year 2006 were given only to newly hired and promoted employees eligible to receive SPSAs.

The actual costsCompany granted SPSAs for fiscal years 2007 and 2008 with performance periods of these settlements will be less than that maximum amount, depending onJuly 1, 2006 through June 30, 2007 and July 1, 2007 through June 30, 2008, respectively. At the end of the fiscal year performance period, the number of class members and schools who are issued and redeem vouchers.shares of stock subject to the award is determined by multiplying the target award by a percentage ranging from 0% to 150%. The settlementspercentage is based on performance metrics for the performance period, as determined by the Compensation Committee of the Board of Directors in Arizona, California, the Districtits sole discretion. An additional number of Columbia, Florida, Kansas, Massachusetts, Minnesota, Montana, Nebraska, New Mexico, New York, North Carolina, North Dakota, South Dakota, Tennessee, Vermont, and West Virginia have received final court approval. We estimateshares, approximately 15% of the total costtarget SPSAs, are available as additional awards to resolve all of these cases will range between $1.5 billion and $1.7 billion, with the actual cost dependent upon many unknown 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 process. In accordance with SFAS No. 5,Accounting for Contingencies, and FIN No. 14,Reasonable Estimation of theAmount of a Loss,at June 30, 2006, we have recorded a liability related to these claims of approximately $1.2 billion, which reflects our estimated exposure of $1.5 billion less payments made to date of approximately $300 million, primarily for administrative expenses and legal fees.

Other antitrust litigation and claims.    On August 27, 2004, the City and County of San Francisco, the City of Los Angeles, and Los Angeles, San Mateo, Contra Costa, and Santa Clara Counties filed a putative class action against us in San Francisco Superior Court. The action was broughtparticipants based on behalf of all governmental entities, agencies, and political subdivisionsindividual performance. One-quarter of the Stateshares of California that indirectly purchased our operating system or word processing and spreadsheet software duringstock subject to each award vest following the period from February 18, 1995 to the date of trial in the action. The plaintiffs sought treble damages under California’s Cartwright Act and disgorgement of unlawful profits under its Unfair Competition Act resulting from our alleged combinations to restrain trade, deny competition, and monopolize the world markets for PC operating systems and word processing and spreadsheet applications (and productivity suites including these applications). We removed the case to the U.S. District Court for Maryland. Our motion to dismiss the complaint was granted on April 18, 2005 with leave to file an amended complaint alleging claims under the Cartwright Act based on conduct within the four-year statute of limitation the court ruled applies to the plaintiffs’ claims. We have obtained final approval of settlement of this case, which resolves all claims asserted in the lawsuit.

On November 12, 2004, Novell, Inc. filed a complaint in the U.S. District Court for Utah 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. On June 10, 2005, the trial court granted our motion to dismiss four of six claimsend of the complaint. An appeal of that ruling is now pending and the case is effectively stayed during the appeal.

Patent and intellectual property claims.    We are a defendant in more than 35 patent infringement cases that we are defending vigorously. In the case ofEolas Technologies, Inc. and University of California v. Microsoft, filed in the U.S. District Court for the Northern District of Illinois on February 2, 1999, the plaintiffs alleged infringement by the browser functionality of Windows. On August 11, 2003, the jury awarded the plaintiffs approximately $520 million in damages for infringement from the date the plaintiffs’ patent was issued through September 2001. The plaintiffs are seeking an equitable accounting for damages from September 2001 to the present. On January 14, 2004, the trial court entered final judgment of $565 million, including post-trial interest of $45 million, and entered an injunction against distribution of any new infringing products, but stayed execution of the judgment and the injunction pending our appeal. We appealed and on March 2, 2005 the Court of Appeals for the Federal Circuit reversed the decision and vacated the judgment, ruling that the trial court had erred in excluding certain previous art evidence and ruling as a matter of law on other evidence. The appellate court also reversed the trial court’s decision that the inventors had not engaged in inequitable conduct by failing to reveal material previous art while obtaining the patent. We believe the total cost to resolve this case will not be material to our financial position or results of operations. The actual costs will be dependent upon many unknown factors such as the events of a retrial of the plaintiff’s claims. InMicrosoft v. Lucent, filed in the U.S. District Court in San Diego on April 8, 2003, we are seeking a declaratory judgment that we do not infringe any valid patent among a number of patents Lucent has been asserting against computer manufacturers that sell computers with our software pre-installed. The first in a series of back-to-back trials on the various patent groupings is currently set to begin on November 20, 2006. On March 28, 2006, Lucent filed a new lawsuit against us in U.S. District Court in San Diego, claiming that Xbox 360 violates one of the patents that earlier

 

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had been dismissed from

performance period, and an additional one-quarter of the older lawsuit. In responseshares vest over each of the following three years. Following the end of the fiscal year 2007 performance period, the Compensation Committee of the Board of Directors determined that the number of shares of SAs to Lucent’s new complaint, we asserted patent infringement counterclaims accusing Lucentbe issued was 11 million, based on the actual performance against metrics established for the performance period. The number of infringing ten Microsoft patents by its salesshares of various products. No trial date has been setSAs to be issued for the fiscal year 2008 performance period will be determined in the new lawsuit. InAmado v. Microsoft, filed in U.S. District Court forfirst quarter of fiscal year 2009.

We measure the Central Districtfair value of California on March 7, 2003,SAs and SPSAs based upon the plaintiff has accused the link table functionality available in Microsoft Access when used with Microsoft Excel. After a jury trial, we were found to infringe one claimmarket price of the patent and damages of $8.9 million were awarded. The judge later found for us on our defense of laches, which reduced the damages award to $5.9 million. The court also imposed an injunction against further distributionunderlying common stock as of the accused feature as partdate of Microsoft Access, but stayed the injunction pending resolution of all appeals. The Court of Appeals for the Federal Circuit affirmed the judgment on appeal and Microsoft intends to seek reviewgrant, reduced by the U.S. Supreme Courtpresent value of one issue. InZ4 Technologies, Inc. v. Microsoft,estimated future dividends. SAs and SPSAs are amortized over their applicable vesting period (generally three to five years) using the plaintiff alleged that Microsoft Windows and Office product activation functionality violates its patent rights. In April 2006,straight-line method. The fair value of each award grant is estimated on the jury rendered a $115 million verdict against us. In August 2006,date of grant using the trial court increased damages by $25 million pursuant tofollowing assumptions:

(In millions)  2008  2007  2006

Dividend per share (quarterly amounts)

  $0.10 - $0.11  $ 0.09 - $0.10  $ 0.08 - $0.09

Interest rates range

   2.5% - 4.9%   4.3% - 5.3%   3.2% - 5.3%

During fiscal year 2008, the jury’s finding of willful infringement. We intend to appeal the verdict. InVeritas Operating Corporation v. Microsoft, filed in the U.S. District Court for the Western District of Washington on May 18, 2006, a subsidiary of Symantec has filed an action asserting claims of trade secret misappropriation, breach of contract, and patent infringement relating to certain storage technologies. Adverse outcomes in some or all of the matters described in this paragraph may result in significant monetary damages or injunctive relief against us, adversely affecting distribution offollowing activity occurred under our operating system or application products. The risks associated with an adverse decision may result in material settlements.existing plans:

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. While 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.

    Shares
(in millions)
   Weighted
Average
Grant-Date
Fair Value
Year Ended June 30, 2008       

Stock awards:

    

Nonvested balance, beginning of year

  124   $24.67

Granted

  71    27.83

Vested

  (33)   24.49

Forfeited

  (9)   25.61
      

Nonvested balance, end of year

  153   $26.12
        

Shared performance stock awards:

    

Nonvested balance, beginning of year

  33   $24.11

Granted

  19    27.82

Vested

  (14)   24.07

Forfeited

  (2)   24.44
      

Nonvested balance, end of year

  36   $26.14
        

As of June 30, 2008, there was $3.2 billion and $586 million of total unrecognized compensation costs related to SAs and SPSAs, respectively. These costs are expected to be recognized over a weighted average period of 3.4 years and 2.8 years, respectively.

SPSAs granted in fiscal year 2008 include adjustments for estimated performance against performance targets.

During fiscal year 2007 and 2006, the following activity occurred under our plans:

(In millions, except fair values)  2007  2006

Stock awards granted

   57   47

Weighted average grant-date fair value

  $25.15  $24.70

Shared performance stock awards granted

   11   3

Weighted average grant-date fair value

  $25.18  $24.80

Stock Options.    In fiscal year 2004, we had accrued aggregate liabilities totaling $1.0began granting employees SAs rather than stock options as part of our equity compensation plans. Since then, stock options issued to employees have been issued primarily in conjunction with business acquisitions. Nonqualified stock options were granted to our directors under our non-employee director

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stock plan. Nonqualified and incentive stock options were granted to certain officers and employees under our employee stock plans. Options granted between 1995 and 2001 generally vest over four and one-half years and expire seven years from the date of grant, while certain options vest either over four and one-half years or over seven and one-half years and expire ten years from the date of grant. Options granted after 2001 vest over four and one-half years and expire ten years from the date of grant. Approximately ten million, two million, and one million stock options were granted in conjunction with business acquisitions during fiscal years 2008, 2007, and 2006, respectively.

Employee stock options outstanding were as follows:

    Shares
(in millions)
   Weighted
Average
Exercise Price
  Weighted
Average
Remaining
Contractual
Term (years)
  Aggregate
Intrinsic
Value
(in millions)

Balance, June 30, 2007

  524   $27.86    

Granted

  10    8.63    

Exercised

  (121)   25.06    

Canceled

  (48)   32.05    

Forfeited

  (1)   15.58    
        

Balance, June 30, 2008

  364   $28.12  3.01  $1,029

Exercisable, June 30, 2008

  357   $28.12  2.95  $899

Options outstanding as of June 30, 2008 include approximately 12 million options that were granted in conjunction with business acquisitions. While these options are included in the options outstanding balance, they are excluded from the weighted average exercise price of $28.12 presented. These options have an exercise price range of $0 to $150.93 and a weighted average exercise price of $9.03.

During fiscal years 2008, 2007, and 2006 the following activity occurred under our plans:

(In millions)  2008  2007  2006

Total intrinsic value of stock options exercised

  $1,042  $818  $491

Total fair value of stock awards vested

  $804  $566  $377

Total fair value of shared performance stock awards vested

  $336  $292  $

Cash received and income tax benefits from stock option exercises were $3.0 billion in other current liabilities and $1.0 billion in other long-term liabilities$365 million, respectively, 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 which we estimate could be up to $1.0 billion in aggregate beyond recorded amounts. Were an unfavorable final outcome to occur, there exists the possibility of a material adverse impact on the Company’s financial position and on the results of operations for the period in which the effect becomes reasonably estimable.fiscal year 2008.

NOTE 1819    SEGMENT INFORMATION

Segment revenue and operating income/income (loss) was as follows:

 

(In millions)            
Year Ended June 30  2006  2005  2004

Revenue

      

Client

  $13,001  $11,972  $11,293

Server and Tools

   10,542   9,197   8,031

Information Worker

   12,380   11,702   10,990

Microsoft Business Solutions

   906   776   735

MSN

   2,488   2,486   2,498

Mobile and Embedded Devices

   365   259   185

Home and Entertainment

   4,292   3,110   2,731

Reconciling amounts

   308   286   372
         

Consolidated

  $44,282  $39,788  $36,835
            
(In millions)            
Year Ended June 30,  2008  2007  2006

Revenue:

      

Client

  $16,472  $14,844  $13,077

Server and Tools

   13,189   11,184   9,670

Online Services Business

   3,214   2,441   2,303

Microsoft Business Division

   18,937   16,404   14,461

Entertainment and Devices Division

   8,139   6,066   4,761

Unallocated and other

   469   183   10
         

Consolidated

  $60,420  $51,122  $44,282
            

 

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(In millions)             
Year Ended June 30  2006  2005  2004 

Operating Income/(Loss)

    

Client

  $10,043  $9,418  $9,061 

Server and Tools

   3,525   2,922   2,357 

Information Worker

   8,982   8,726   8,160 

Microsoft Business Solutions

   14   (134)  (91)

MSN

   111   477   393 

Mobile and Embedded Devices

   (11)  (37)  (116)

Home and Entertainment

   (1,283)  (451)  (1,011)

Reconciling amounts

   (4,909)  (6,360)  (9,719)
          

Consolidated

  $16,472  $14,561  $9,034 
             

(In millions)              
Year Ended June 30,  2008  2007   2006 

Operating Income (Loss):

     

Client

  $12,537  $11,338   $10,176 

Server and Tools

   4,261   3,593    2,980 

Online Services Business

   (1,309)  (630)   194 

Microsoft Business Division

   12,182   10,696    9,567 

Entertainment and Devices Division

   267   (2,016)   (1,329)

Reconciling amounts

   (5,446)  (4,457)   (5,116)
           

Consolidated

  $22,492  $18,524   $16,472 
              

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. Fiscal years 2005 and 2004 amounts have been restated for certain internal reorganizations and to conform to the current period presentation. The segments are designed to allocate resources internally and provide a framework to determine management responsibility. Amounts for prior periods have been recast to conform to the current management view. 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 sevenfive segments are Client; Server and Tools; Information Worker;Online Services Business; Microsoft Business Solutions; MSN; MobileDivision; and Embedded Devices;Entertainment and Home and Entertainment. On July 17, 2006 we announced a change in our operating segments reflecting the culmination of our realignment announced in September 2005. These changes will be effective for fiscal year 2007; the seven segments discussed in this analysis are presented the way we internally managed and monitored performance at the business group level in fiscal years 2006, 2005, and 2004.Devices Division.

The types of products and services provided by each segment are summarized below:

Client Windows Vista, including Home, Home Premium, Ultimate, Business, Enterprise and Starter Edition; Windows XP Professional and Home; Media Center Edition; Tablet PC Edition; and other standard Windows operating systems.

Server and Tools –Windows– Windows Server operating system; Microsoft SQL Server; Exchange Server; Microsoft ConsultingEnterprise Services; product support services; Visual Studio; System Center products,products; Forefront security family of products; Biz Talk Server; MSDN; and Biz Talk.other products and services.

Information WorkerOnline Services Business – Live Search; MSN; MapPoint; MSN Internet Access; MSN Premium Web Services (consisting of MSN Internet Software Subscription, MSN Hotmail Plus, and MSN Software Services); Windows Live; MSN Mobile Services; AvenueA Razorfish media agency services; Atlas online tools for advertisers; and the Drive PM ad network for publishers.

Microsoft Business Division – Microsoft Office; Microsoft Project; Microsoft Visio; Microsoft Office SharePoint Portal Server client access licenses;Server; Microsoft LiveMeeting; OneNote; andPerformancePoint; Microsoft Office Live; FAST ESP; Microsoft Exchange Server; Microsoft Exchange Hosted Services; Microsoft Office Live Meeting; Microsoft Office Communication Server.

Server; Microsoft Business Solutions –Office Communicator; Microsoft Tellme Service, Microsoft Dynamics AX; Microsoft Dynamics CRM; Microsoft Dynamics CRM Online; Microsoft Dynamics GP; Microsoft Dynamics NAV; Microsoft Dynamics SL; Microsoft Dynamics Retail Management System; Microsoft Partner Program; and Microsoft Office Small Business Accounting.

MSNEntertainment and Devices DivisionMSN Search; MapPoint; MSN Internet Access; MSN Premium Web Services (consisting of MSN Internet Software Subscription, MSN Hotmail Plus, MSN Bill Pay,Xbox 360 console and MSN Radio Plus);games; Xbox Live; Zune; Mediaroom; numerous consumer software and MSN Mobile Services.

Mobilehardware products (such as mice and Embedded Devices –keyboards); Windows Mobile software and services platform; Windows Embedded device operating system; Windows Automotive; and Windows Automotive.

Home and Entertainment – Xbox 360; Xbox; Xbox Live; CPxG (consumer software and hardware products); and IPTV.Surface computing platform.

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

 

PAGE 6970


 Part II 

Item 8

 

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.

Assets are not allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment and it is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss.

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, period-end cut-off timing, 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.

Significant reconciling items were as follows:

 

(In millions)                        
Year Ended June 30  2006 2005 2004 
Year Ended June 30,  2008 2007   2006 

Operating income reconciling amounts:

    

Legal settlements and contingent liabilities

  $(1,321) $(2,312) $(2,832)

Summary of reconciling amounts:

     

Corporate-level activity(1)

  $(6,704) $(4,777)  $(4,804)

Stock-based compensation expense

   (127)  (1,042)  (4,516)   844   123    (173)

Revenue reconciling amounts

   308   286   372    368   120    (7)

Corporate-level expenses(1)

   (3,742)  (3,493)  (3,128)

Other

   (27)  201   385    46   77    (132)
                

Total

  $(4,909) $(6,360) $(9,719)  $(5,446) $(4,457)  $(5,116)
                     

 

(1) 

Corporate-level expenses exclude legal settlements and contingent liabilities,activity excludes stock-based compensation expense and revenue reconciling amounts presented separately in those line items.

No sales to an individual customer accounted for more than 10% of fiscal year 2008 or fiscal year 2007 revenue. Sales to Dell and its subsidiaries in the aggregate accounted for approximately 11% of fiscal year 2006 and 10% of total fiscal year 2005 and 2004 revenue. These sales were made primarily through our OEM and volume licensing channels and were included in allcover a broad array of products including Windows PC operating segments.systems, Microsoft Office, and server products.

Revenue, classified by the major geographic areas in which our customers are located, werewas as follows:

 

(In millions)                        
Year Ended June 30  2006  2005  2004
Year Ended June 30,  2008  2007  2006

United States(1)

  $29,730  $26,949  $25,046  $35,928  $31,346  $27,957

Other countries

   14,552   12,839   11,789   24,492   19,776   16,325
             

Total

  $44,282  $39,788  $36,835  $60,420  $51,122  $44,282
                  

 

(1) 

Includes shipments to customers in the United States and licensing to certain OEMs and multinational organizations.

Long-lived assets, classified by the geographic location of the controlling statutory company in which that company operates, were as follows:

 

(In millions)                
Year Ended June 30  2006  2005
Year Ended June 30,  2008  2007

United States

  $6,661  $5,506  $19,129  $9,132

Other countries

   788   648   1,194   856
       

Total

  $7,449  $6,154  $20,323  $9,988
            

 

PAGE70


 Part II 

Item 8

NOTE 19    SUBSEQUENT EVENTS

On July 12, 2006, the European Commission imposed a fine of281 million ($351 million) on Microsoft related to the Commission’s March 2004 decision in its competition law investigation. As of June 30, 2006, the total amount of the fine was included in other current liabilities.

On July 20, 2006, we announced that our Board of Directors authorized two new share repurchase programs, comprised of a $20 billion tender offer which was completed on August 17, 2006, and an additional $20 billion ongoing share repurchase program with an expiration of June 30, 2011. Under the tender offer, we repurchased approximately 155 million shares of our common stock, or approximately 1.5% of our common stock outstanding, for approximately $3.8 billion at a per share price of $24.75.

On August 18, 2006, we announced that the authorization for the ongoing share repurchase program, previously announced on July 20, 2006, had been increased by approximately $16.2 billion. As a result, the company is authorized to repurchase additional shares in an amount up to $36.2 billion through June 30, 2011.

 

PAGE 71


 Part II 

Item 8

 

QUARTERLY INFORMATION

 

(In millions, except per share amounts) (Unaudited)                                
Quarter Ended  Sep. 30 Dec. 31 Mar. 31 June 30 Total  Sep. 30 Dec. 31 Mar. 31 June 30 Total

Fiscal year 2008

      

Revenue

  $13,762  $16,367  $14,454  $15,837  $60,420

Gross profit

   11,087   12,824   11,940   12,971   48,822

Net income

   4,289   4,707(1)  4,388(2)  4,297   17,681

Basic earnings per share

   0.46   0.50   0.47   0.46   1.90

Diluted earnings per share

   0.45   0.50   0.47   0.46   1.87
            

Fiscal year 2007

      

Revenue

  $10,811  $12,542(3) $14,398(4) $13,371  $51,122

Gross profit

   9,115   8,922   12,258   10,134(6)  40,429

Net income

   3,478   2,626   4,926(5)  3,035   14,065

Basic earnings per share

   0.35   0.27   0.51   0.32   1.44

Diluted earnings per share

   0.35   0.26   0.50   0.31   1.42
            

Fiscal year 2006

            

Revenue

  $9,741  $11,837  $10,900  $11,804  $44,282  $9,741  $11,837  $10,900  $11,804  $44,282

Gross profit

   8,488   9,598   8,872   9,674   36,632   8,488   9,598   8,872   9,674   36,632

Net income

   3,141(6)  3,653   2,977(7)  2,828(8)  12,599   3,141(7)  3,653   2,977(8)  2,828(9)  12,599

Basic earnings per share

   0.29   0.35   0.29   0.28   1.21   0.29   0.35   0.29   0.28   1.21

Diluted earnings per share

   0.29   0.34   0.29   0.28   1.20   0.29   0.34   0.29   0.28   1.20
            

Fiscal year 2005

      

Revenue

  $9,189  $10,818  $9,620  $10,161  $39,788

Gross profit

   7,784   8,943   8,257   8,773   33,757

Net income

   2,528(3)  3,463   2,563(4)  3,700(5)  12,254

Basic earnings per share

   0.23   0.32   0.24   0.34   1.13

Diluted earnings per share

   0.23   0.32   0.23   0.34   1.12
            

Fiscal year 2004

      

Revenue

  $8,215  $10,153  $9,175  $9,292  $36,835

Gross profit

   6,735   7,809   7,764   7,811   30,119

Net income

   2,614   1,549(1)  1,315(2)  2,690   8,168

Basic earnings per share

   0.24   0.14   0.12   0.25   0.76

Diluted earnings per share

   0.24   0.14   0.12   0.25   0.75

 

(1) 

Includes stock-based compensation charges totaling $2.2 billion for the employee stock option transfer program.of $237 million (pre-tax) related to various legal matters.

(2) 

Includes charges totaling $2.53charge of $1.4 billion (pre-tax)(899 million) related to the Sun Microsystems Inc. settlement and a fine imposed by the European Commission.Commission in February 2008.

(3) Includes charges totaling $536 million (pre-tax) related

Reflects $1.6 billion of revenue deferred to the settlementthird quarter of certain litigation with Novell, Inc.fiscal year 2007 for the Express Upgrade to Windows Vista and Microsoft Office Technology guarantee programs and pre-shipments of Windows Vista and the 2007 Microsoft Office system.

(4) 

Includes charges totaling $768 million (pre-tax) related to the Gateway, Inc. and Burst.com settlements, Sun Microsystems, Inc., and additional charges related to anti-trust and certain other matters.$1.6 billion of revenue discussed above.

(5) 

Includes charges totaling $756of $296 million (pre-tax) related to IBM and othervarious legal matters.

(6) 

Includes $1.1 billion (pre-tax) charge related to the Xbox 360 warranty policy, inventory write-downs, and product returns.

(7)

Includes charge of $361 million (pre-tax) related to the settlement with RealNetworks, Inc.

(7)(8) 

Includes charges of $397 million (pre-tax) related to various legal charges.matters.

(8)(9) 

Includes charge of $351 million (281 million ($351 million)(pre-tax) as a result of the fine imposed by the European Commission in July 2006.

 

PAGE 72


 Part II 

Item 8

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of Microsoft Corporation:

We have audited the accompanying consolidated balance sheets of Microsoft Corporation and subsidiaries (the “Company”) as of June 30, 20062008 and 2005,2007, and the related consolidated statements of income, cash flows, and stockholders’ equity for each of the three years in the period ended June 30, 2006.2008. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Microsoft Corporation and subsidiaries as of June 30, 20062008 and 2005,2007, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 2006,2008, in conformity with accounting principles generally accepted in the United States of America.

As discussed in Note 1 to the financial statements, on July 1, 2007 the Company adopted the provisions of Financial Accounting Standards Board Interpretation No. 48,Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 and Emerging Issues Task Force Issue No. 06-2,Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of June 30, 2006,2008, based on the criteria established inInternal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated August 22, 2006,July 31, 2008 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

/s/    DELOITTE & TOUCHE LLP

Seattle, Washington

August 22, 2006July 31, 2008

 

PAGE 73


 Part II 

Item 9, 9A

 

ITEM 9.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS

ON ACCOUNTING AND FINANCIAL DISCLOSURE

Not applicable.

ITEM 9A.    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 pursuant toas 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.

REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Our management is responsible for establishing and maintaining adequate internal control over financial reporting for the company. Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of our financial statements; providing reasonable assurance that receipts and expenditures of company assets are made in accordance with management authorization; and providing reasonable assurance that unauthorized acquisition, use, or disposition of company assets that could have a material effect on our financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a misstatement of our financial statements would be prevented or detected.

Management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework inInternal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that the company’s internal control over financial reporting was effective as of June 30, 2006.2008. There were no changes in our internal control over financial reporting during the quarter ended June 30, 20062008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Deloitte & Touche LLP has audited this assessment of our internal control over financial reporting;reporting as of June 30, 2008; their report is included in Item 9A.

 

PAGE 74


 Part II 

Item 9A

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of Microsoft Corporation:

We have audited management’s assessment, included in the accompanying Reportinternal control over financial reporting of Management on Internal Control over Financial Reporting, that Microsoft Corporation and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of June 30, 2006,2008, based on criteria established inInternal Control—Control – Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting.reporting, included in the accompanying Report of Management on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment,assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.opinion.

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of June 30, 2006, is fairly stated, in all material respects, based on the criteria established inInternal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of June 30, 2006,2008, based on the criteria established inin Internal Control—Control – Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended June 30, 20062008 of the Company and our report dated August 22, 2006July 31, 2008 expressed an unqualified opinion on those financial statements.statements and included an explanatory paragraph regarding the Company’s adoption of Financial Accounting Standards Board Interpretation No. 48,Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 and Emerging Issues Task Force Issue No. 06-2,Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43.

/s/    DELOITTE & TOUCHE LLP

Seattle, Washington

August 22, 2006July 31, 2008

 

PAGE 75


 Part II, III 

Item 9B, 10, 11, 12, 13, 14

 

ITEM 9B.    OTHER INFORMATION

Effective August 23, 2006, the Board of Directors amended the Company’s bylaws. The Board added a new Section 1.13 concerning the right of shareholders to amend the bylaws, which they already have pursuant to the Washington Business Corporation Act. The board also added a new paragraph to Section 2.2 to incorporate the Board’s previous governance policy on election of directors. The Board added additional procedures that would be followed if a director does not receive a majority of shares cast in an uncontested election.Not applicable.

PART III

ITEM 10.    DIRECTORS, AND EXECUTIVE OFFICERS OF THE REGISTRANTAND CORPORATE GOVERNANCE

A list of our executive officers and biographical information appears in Part I, Item 1 of this report. Information about our Directorsdirectors may be found under the caption “Election of Directors and Management Information” of“Nominees” in our Proxy Statement for the Annual Meeting of Shareholders to be held November 14, 200619, 2008 (the “Proxy Statement”). Information about our Audit Committee may be found under the caption “Board Committees” in the Proxy Statement. That information is incorporated herein by reference.

The information in the Proxy Statement set forth under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by reference.

We have adopted the Microsoft Finance Code of Professional Conduct (the “finance code of ethics”), a code of ethics that applies to our Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer and Corporate Controller, and other finance organization employees. The finance code of ethics is publicly available on our websiteWebsite at www.microsoft.com/msft.msft/corporate/default.mspx. If we make any substantive amendments to the finance code of ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer, or Chief Accounting Officer and Corporate Controller, we will disclose the nature of suchthe amendment or waiver on that websiteWebsite or in a report on Form 8-K.

ITEM 11.    EXECUTIVE COMPENSATION

The information in the Proxy Statement set forth under the captions “Information Regarding“Director Compensation,” “Named Executive Officer Compensation”Compensation,” “Compensation Committee Interlocks and “Information About the BoardInsider Participation,” and its Committees – Director Compensation”“Compensation Committee Report” is incorporated herein by reference.

ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The information in the Proxy Statement set forth under the captions “Equity Compensation Plan Information” and “Information Regarding Beneficial Ownership of Principal Shareholders, Directors, and Management” is incorporated herein by reference.

ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

The information set forth in the Proxy Statement under the captions “Director Independence” and “Certain Relationships and Related Transactions” of the Proxy Statement is incorporated herein by reference.

ITEM 14.    PRINCIPAL ACCOUNTANTACCOUNTING FEES AND SERVICES

Information concerning principal accountant fees and services appears in the Proxy Statement under the headingheadings “Fees Billed by Deloitte & Touche LLP”Touche” and “Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditor” and is incorporated herein by reference.

 

PAGE 76


 Part IV 

Item 15

 

PART IV

ITEM 15.    EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a) Financial Statements and Schedules

The financial statements are set forth under Item 8 of this Annual Report on Form 10-K. Financial statement schedules have been omitted since they are either not required, not applicable, or the information is otherwise included.

(b) Exhibit Listing

 

        Incorporated by reference     Filed
herewith
  Incorporated by reference
Exhibit
number
  Exhibit description  Filed
herewith
  Form  Period
ending
  Exhibit  Filing date  Exhibit description  Form  Period
ending
  Exhibit  Filing date
3.1  Amended and Restated Articles of Incorporation of Microsoft Corporation    10-Q  12/31/02  3.1  1/31/03  Amended and Restated Articles of Incorporation of Microsoft Corporation    10-Q  12/31/02  3.1  1/31/03
3.2  Bylaws of Microsoft Corporation  X          Bylaws of Microsoft Corporation    10-K  6/30/07  3.2  8/3/07
4  Call Option Transaction Confirmation dated December 11, 2003 between Microsoft Corporation and JPMorgan Chase Bank    10-K  12/31/03  4  2/6/04
10.1*  Microsoft Corporation 2001 Stock Plan    8-K    99.2  7/21/06  Microsoft Corporation 2001 Stock Plan    8-K    99.2  7/21/06
10.2*  Microsoft Corporation 1991 Stock Option Plan    8-K    99.1  7/21/06  Microsoft Corporation 1991 Stock Option Plan    8-K    99.1  7/21/06
10.3*  Microsoft Corporation 1999 Stock Plan for Non-Employee Directors    8-K    10.3  11/15/04  Microsoft Corporation 1999 Stock Plan for Non-Employee Directors    8-K    10.3  11/15/04
10.4*  Microsoft Corporation Stock Option Plan for Non-Employee Directors    8-K    10.4  11/15/04  Microsoft Corporation Stock Option Plan for Non-Employee Directors    8-K    10.4  11/15/04
10.5*  Microsoft Corporation Stock Option Plan for Consultants and Advisors    8-K    10.5  11/15/04  Microsoft Corporation Stock Option Plan for Consultants and Advisors    8-K    10.5  11/15/04
10.6*  Microsoft Corporation 2003 Employee Stock Purchase Plan    10-K  6/30/04  10.6  9/1/04  Microsoft Corporation 2003 Employee Stock Purchase Plan    10-K  6/30/04  10.6  9/1/04
10.7*  Microsoft Corporation Deferred Compensation Plan    S-8    99.1  2/28/06  Microsoft Corporation Deferred Compensation Plan    S-8    99.1  2/28/06
10.8*  Form of Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan  X          Form of Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan    10-K    10.8  8/25/06
10.9*  Form of Stock Award Agreement for Non-Employee Directors under the Microsoft Corporation 1999 Stock Plan for Non-Employee Directors    10-K  6/30/04  10.9  9/1/04  Form of Stock Award Agreement for Non-Employee Directors under the Microsoft Corporation 1999 Stock Plan for Non-Employee Directors    10-K  6/30/04  10.9  9/1/04
10.10*  Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the January 1, 2004 to June 30, 2006 performance period    10-K  6/30/04  10.10  9/1/04  Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the January 1, 2004 to June 30, 2006 performance period    10-K  6/30/04  10.10  9/1/04

 

PAGE 77


 Part IV 

Item 15

 

         Incorporated by reference
Exhibit
number
  Exhibit description  Filed
herewith
  Form  Period
ending
  Exhibit  Filing date
10.11*  Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the July 1, 2003 to June 30, 2006 performance period   10-K  6/30/04  10.11  9/1/04
10.12*  Form of Stock Option Agreement under the Microsoft Corporation 2001 Stock Plan   10-K  6/30/04  10.12  9/1/04
10.13*  Form of Stock Option Agreement for Non-Employee Directors under the 1999 Stock Plan for Non-Employee Directors   10-K  6/30/04  10.13  9/1/04
10.14  Trust Agreement dated June 1, 1993 between Microsoft Corporation and BNY Western Trust Company as trustee (formerly with First Interstate Bank of Washington as trustee)   10-K  6/30/02  10.8  9/6/02
10.15  Trust Agreement dated June 30, 2003 between Microsoft Corporation and BNY Western Trust Company as trustee   10-K  6/30/03  10.8  9/5/03
10.16*  Microsoft Corporation Deferred Compensation Plan for Non-Employee Directors   S-8    99.2  2/28/06
21  Subsidiaries of Registrant  X           
23.1  Consent of Independent Registered Public Accounting Firm  X        
31.1  Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002  X        
31.2  Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002  X        
32.1  Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002  X        
32.2  Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002  X        

      Filed
herewith
  Incorporated by reference

Exhibit

number

  Exhibit description    Form  Period
ending
  Exhibit  Filing date
10.11*  Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the July 1, 2003 to June 30, 2006 performance period    10-K  6/30/04  10.11  9/1/04
10.12*  Form of Stock Option Agreement under the Microsoft Corporation 2001 Stock Plan    10-K  6/30/04  10.12  9/1/04
10.13*  Form of Stock Option Agreement for Non-Employee Directors under the 1999 Stock Plan for Non-Employee Directors    10-K  6/30/04  10.13  9/1/04
10.14  Trust Agreement dated June 1, 1993 between Microsoft Corporation and BNY Western Trust Company as trustee (formerly with First Interstate Bank of Washington as trustee)    10-K  6/30/02  10.8  9/6/02
10.15  Trust Agreement dated June 30, 2003 between Microsoft Corporation and BNY Western Trust Company as trustee    10-K  6/30/03  10.8  9/5/03
10.16*  Microsoft Corporation Deferred Compensation Plan for Non-Employee Directors    S-8    99.2  2/28/06
10.17*  Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the fiscal year 2007 performance period    10-K  6/30/07  10.17  8/3/07
10.18*  Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the fiscal year 2008 performance period    10-Q  12/31/07  10.18  1/24/08
21  Subsidiaries of Registrant  X        
23.1  Consent of Independent Registered Public Accounting Firm  X        
31.1  Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002  X        
31.2  Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002  X        
32.1  Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002  X        
32.2  Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002  X        

* 

Indicates a management contract or compensatory plan or arrangement

 

PAGE 78


 

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on August 25, 2006.July 31, 2008.

 

MICROSOFT CORPORATION

By:

 

/S/    FRANK H. BROD        

 

Frank H. Brod

 

Corporate Vice President, Finance and
Administration; Chief Accounting Officer
(Principal (Principal Accounting Officer)

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Registrant and in the capacities indicated on August 25, 2006.July 31, 2008.

 

Signature  Title

/s/    WILLIAM H. GATES III        

William H. Gates III

  Chairman

/s/    STEVEN A. BALLMER        

Steven A. Ballmer

  Director and Chief Executive Officer

/s/    JAMES I. CASH, JR.        

James I. Cash, Jr.

  Director

/s/    DINA DUBLON        

Dina Dublon

  Director

/s/    RAYMOND V. GILMARTIN        

Raymond V. Gilmartin

  Director

/s/    ARNNEED MHCLAUGHLIN KOROLOGOSASTINGS        

Ann McLaughlin KorologosReed Hastings

  Director

/s/    DAVID F. MARQUARDT        

David F. Marquardt

  Director

/s/    CHARLES H. NOSKI        

Charles H. Noski

  Director

/s/    HELMUT PANKE        

Helmut Panke

  Director

/s/    JON A. SHIRLEY        

Jon A. Shirley

  Director

/s/    CHRISTOPHER P. LIDDELL        

Christopher P. Liddell

  

Senior Vice President, Finance and Administration;
President;

Chief Financial Officer

(Principal Financial Officer)

/s/    FRANK H. BROD        

Frank H. Brod

  

Corporate Vice President, Finance and Administration;
Chief Accounting Officer

(Principal Accounting Officer)

 

PAGE 79