UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the Quarterly Period Ended December 31, 2005September 30, 2006

OR

For the Transition Period From              to             

Commission File Number: 0-14278

MICROSOFT CORPORATION

(Exact name of registrant as specified in its charter)

(425) 882-8080

(Registrant’s telephone number, including area code)

None

(Former name, former address and former fiscal year, if changed since last report)

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 whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

MICROSOFT CORPORATION

FORM 10-Q

For the Quarter Ended December 31, 2005September 30, 2006

INDEX

Part I. Financial Information

Item 1. Financial Statements

MICROSOFT CORPORATION

INCOME STATEMENTS

(In millions, except per share amounts)(Unaudited)

See accompanying notes.

MICROSOFT CORPORATION

BALANCE SHEETS

(In millions)

See accompanying notes.

MICROSOFT CORPORATION

CASH FLOWS STATEMENTS

(In millions)(Unaudited)

See accompanying notes.

MICROSOFT CORPORATION

STOCKHOLDERS’ EQUITY STATEMENTS

(In millions)(Unaudited)

See accompanying notes.

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS

(Unaudited)

Note 1 – Basis of Presentation and Consolidation

Basis of Presentation

In the opinion of management, the accompanying balance sheets and related interim statements of income, cash flows, and stockholders’ equity include all adjustments, consisting only of normal recurring items, necessary for their fair presentation in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”). Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples include estimates of loss contingencies, product life cycles, and stock-based compensation forfeiture rates; and 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; and determining when investment impairments are other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions.

Interim results are not necessarily indicative of results for a full year. The information included in this Form 10-Q should be read in conjunction with Management’s Discussion and Analysis and the financial statements and notes thereto included in the Microsoft Corporation 20052006 Form 10-K.

CertainAs discussed in Note 8, effective July 1, 2006, we reorganized our business into five operating segments, organized under one of three operating divisions. Accordingly, we have restated prior year amounts have been reclassifiedperiod segment information to conform to the current period presentation, including reclassifications in the statements of cash flows for the previously disclosed reclassification of auction rate securities as short-term investments instead of cash and equivalents in accordance with guidance issued by the Securities and Exchange Commission and the reclassification of non-current tax contingencies from non-current deferred taxes to other non-current liabilities.presentation. There was no impact on net income as a result of these reclassifications.the consolidated financial statements.

Basis of Consolidation

The financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments in which we exercise significant influence but do not exercise control and are not the primary beneficiary are accounted for using the equity method. Investments in which we are not able to exercise significant influence over the investee are accounted for under the cost method.

Note 2 – Inventories, net

Components of inventories arewere as follows:

Note 3 – 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.

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Components of basic and diluted earnings per share arewere as follows:

The following shares attributable to outstanding stock options were excluded from the calculation of diluted earnings per share because their inclusion would have been anti-dilutive. In addition, the following shared performance stock awards 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:period.

Note 4 – Unearned Revenue

Components of unearned revenue arewere as follows:

Unearned revenue by segment iswas as follows:

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Note 5 – Stockholders’ Equity

On October 26, 2005,July 20, 2006, we announced that our Board of Directors approved a modification to the July 20, 2004authorized two new share repurchase plan. The original repurchase plan calledprograms: a $20 billion tender offer, which was completed on August 17, 2006; and authorization for up to $30an additional $20 billion ongoing share repurchase program with an expiration of MicrosoftJune 30, 2011. Under the tender offer, we repurchased approximately 155 million shares of common stock, or 1.5% of our common shares outstanding, for approximately $3.8 billion at a price per share of $24.75. On August 18, 2006, we announced that the authorization for the $20 billion ongoing share repurchase program had been increased by approximately $16.2 billion. As a result, we are authorized to be repurchased over the succeeding four years. Under the revised plan, we expectrepurchase additional shares in an amount up to complete the $30$36.2 billion approved repurchase amount no later than December 2006.through June 30, 2011. As of December 31, 2005,September 30, 2006, approximately $11.3$35.3 billion remained of the $30$36.2 billion approved repurchase amount. All repurchases will bewere made using cash resources. The repurchase program may be suspended or discontinued at any time without notice. In any period, cash used in financing activities related to common stock repurchased may differ from the comparable change in stockholders’ equity, reflecting timing differences between the recognition of share repurchase transactions and their settlement for cash.

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

We repurchased the following shares of common stock under the above-described repurchase plan:plans:

On September 22,13, 2006, our Board of Directors declared a regular quarterly dividend of $0.10 per share. The dividend is payable on December 14, 2006, to shareholders of record at the close of business on November 16, 2006. The ex-dividend date is November 14, 2006. This dividend of approximately $983 million was included in other current liabilities on our balance sheet.

On September 23, 2005, our Board of Directors declared a regular quarterly dividend of $0.08 per share. The dividend of approximately $846 million was paid on December 8, 2005, to shareholders of record at the close of business on November 17, 2005. On December 14, 2005, our Board of Directors declared a regular quarterly dividend of $0.09 per share. The dividend is payable March 9, 2006, to shareholders of record at the close of business on February 17, 2006. The ex-dividend date is Februarywas November 15, 2006. This dividend of approximately $935 million was included in other current liabilities on our balance sheet as of December 31, 2005.

On July 20, 2004, our Board of Directors declared a regular quarterly dividend of $0.08 per share and a one-time special dividend of $3.00 per share. On September 15, 2004, the Board declared a second regular quarterly dividend of $0.08 per share and on December 8, 2004, the Board declared a regular quarterly dividend of $0.08 per share.

Note 6 – Stock-Based Compensation

Effective July 1, 2005, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R),Share-Based Payment,using the modified prospective application transition method. Because the fair value recognition provisions 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.

Our net income for the three and six months ended December 31, 2005 includes $514 million and $978 million, respectively, of compensation costs and $180 million and $342 million, respectively, of income tax benefits related to our stock-based compensation arrangements. Our net income for the three and six months ended December 31, 2004 includes $551 million and $1.30 billion, respectively, of compensation costs and $193 million and $454 million, respectively, of income tax benefits related to our stock-based compensation arrangements.

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

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.

Shared Performance Stock Awards (“SPSAs”) are a form of SAs in which the number of shares ultimately received depends on our performance against specified performance targets. The performance period is July 1, 2003 through June 30, 2006 (January 1, 2004 through June 30, 2006 for certain executive officers). At the end of the performance period, the number of shares of stock and SAs issued will be determined by adjusting upward or downward from the target in a range between 33% and 150% (0% to 150% for certain executive officers). The final performance percentage on which the payout will be based, considering performance metrics established for the performance period, will be determined by our Board of Directors or a Committee of the Board at its sole discretion. Shares of stock will be issued following the end of the performance period and as the SAs vest ratably over the following two years. Because these awards cover a three-year period, SPSAs generally will only be awarded in fiscal year 2006 to newly hired and promoted employees eligible to receive SPSAs.

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, using an expected quarterly dividend rate of $0.08 ($0.09 beginning December 2005) and risk-free interest rates ranging from 3.6% to 4.5%. SAs and SPSAs are amortized over their applicable vesting period (generally five years) using the straight-line method.

The following activity has occurred under our existing plans:

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

As of December 31, 2005, there was $1.8 billion and $448 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 3.9 years and 2.7 years, respectively.

During the three and six months ended December 31, 2004, the following activity occurred under our plans:

Stock Options. Nonqualified stock options have been granted to our directors under our non-employee director stock plan. Nonqualified and incentive stock options have been 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. No stock options were granted during the three months ended December 31, 2005 or the three or six months ended December 31, 2004. Approximately 1.3 million stock options were granted in conjunction with business acquisitions during the six months ended December 31, 2005.

A summary of option activity under the plans for the three and six months ended December 31, 2005 is as follows:

As of December 31, 2005, 243 million options transferred to JPMorgan remained outstanding and are excluded from the amount noted as options outstanding in the table above. Included in the options outstanding balance are approximately five million options that were granted in conjunction with business acquisitions.

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

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 $170.87 and a weighted average exercise price of $11.51.

As of December 31, 2005, there was $729 million of total unrecognized compensation costs related to stock options. These costs are expected to be recognized over a weighted average period of 1.2 years.

During the three and six months ended December 31, 2005 and 2004, the following activity occurred under our plans:

Cash received from stock option exercises for the three and six months ended December 31, 2005 was $377 million and $1.26 billion, respectively. The income tax benefits from stock option exercises totaled $34 million and $108 million for the three and six months ended December 31, 2005.

At December 31, 2005, an aggregate of 805 million shares were authorized for future grant under our stock plans, which cover stock options, SAs, and SPSAs. Awards that expire or are cancelled without delivery of shares generally become available for issuance under the plans. The options transferred to JPMorgan 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.

We issue new shares to satisfy stock option exercises. Under our revised share repurchase plan approved by our Board of Directors on October 26, 2005, we anticipate that shares repurchased will reduce the dilutive impact of our share-based arrangements. We currently expect the planned repurchase amount of $30 billion to be completed no later than December 2006; however, as this repurchase program may be suspended or discontinued at any time without notice, the timing and amount of repurchases is not known. Based upon the foregoing, it is not practical to present an estimate of the number of shares expected to be repurchased during fiscal year 2006.

Employee Stock Purchase Plan. We have an employee stock purchase plan for all eligible employees. Under this plan, shares of our common stock currently 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. During the three and six months ended December 31, 2005, we issued 3.8 million and 9.1 million shares, respectively, under our employee stock purchase plan at an average price of $23.44 per share and $23.22 per share, respectively. At December 31, 2005, 150.6 million shares were reserved for future issuance under this plan.

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Note 76 – Investment Income and Other

Components of investment income and other arewere as follows:

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Note 87 – Contingencies

Government competition law matters. OnIn March 25, 2004, the European Commission announcedissued a decision in its competition law investigation of Microsoft.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 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 of €497 million which resulted in a charge in the third quarter of fiscal year 2004 of €497 million ($605 million). We filed an appeal ofappealed the decision to the Court of First Instance, on June 6, 2004. On December 22,the basis that we did not infringe European competition law. In July 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 of €281 million ($351 million). We have appealed this fine to 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 date for the appeal is expected to be determined in February 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. The Statement of Objections could result in further monetary fines of up to €2 million per day from December 15, 2005 and other obligations. We are disputing that finding.First Instance.

OnIn December 7, 2005, the Korean Fair Trade Commission (“KFTC”) announced a ruling in its investigation of Microsoft,us, holding that we abused a market dominant position and engaged in unfair trade practices under the Korean Fair Trade LawAct by incorporating instant messaging and media player functionality into the Windows clientPC operating system, and streaming media technologies into the Windows server operating system. The KFTC also announced the impositionimposed a fine of remedies. With respect to media playerapproximately $34 million. The KFTC’s ruling and instant messenger technologies, the Commission announced Microsoft may only distribute two new versionscorrective order issued in February 2006 held that our integration of the Windows client operating system in Korea. The first version must have both the 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 in August 2006, 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, removed. Theprovided the second version may contain our media playerincludes promotional links in the user interface that will enable consumers to link to and instant messenger functionality, but must also contain promotional opportunities for competing media players, so that competing software can be equally installed into the Windows client operating system, and other related modifications. For existing customers, we must produce and distributedownload a compact disk containing competing media players and instant messengers, and develop a Media Player Center and Messenger Center accessible through the Internet, which provide access toselect group of competing media players and instant messengers. A supervisory board will be appointedWe have appealed the KFTC’s decision to determine the specificsSeoul High Court. In May 2006, the KFTC denied our motion for reconsideration of its ruling, but also 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 remedymandated versions of Windows XP Home Edition and to oversee compliance. The Commission will also impose a fine of approximately $32 million. Most of the provisions of the ruling must be implemented within 180 days of the final written decision. A formal written ruling and corrective order implementing the remedies is expected in early calendar

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

year 2006. We will appeal the final decision. Although we have not yet determined how the Commission’s ruling will affect its business in Korea, the announced remedies do not prevent us from distributing Windows in Korea.XP Professional Edition.

In other ongoing investigations, various foreign governments and several state Attorneys Generalattorneys 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 and federal courts on behalf of variously defined classes of direct and indirect purchasers of our personal computers (“PCs”)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 1518 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 are currently on appealwere appealed to the United States U.S.

Court of Appeals for the Fourth Circuit, as istogether with a ruling denying certification of certain proposed classes of

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

U.S. direct purchasers. In April 2006, the Court of Appeals affirmed the trial court decision dismissing the indirect purchaser claims. Courts in twelve18 states have ruled that indirect purchaser cases may proceed as class actions, while courts in two states have denied class certification.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-thirds of the value of vouchers unissued or unredeemed by class members will be made available to certain 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 vouchers to be issued in these settlements, including the California settlement, is approximately $1.9$2.5 billion. The actual costs of these settlements will be less than that maximum amount, depending on the number of class members and schools who are issued and redeem vouchers. The settlements in Arizona, California, the District 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. Settlements in Arkansas and Wisconsin have received preliminary court approval. In Iowa, a jury trial on the plaintiffs’ claims is scheduled to begin in November 2006. We estimate the total cost to resolve all of these cases will range between $1.3$1.5 billion and $1.5$1.8 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 Financial Accounting Standards Board Interpretation (“FIN”)FIN No. 14,Reasonable Estimation of the Amount of a Loss,at December 31, 2005,September 30, 2006, we have recorded a liability related to these claims of approximately $1.1$1.2 billion, netwhich reflects our estimated exposure of $1.5 billion less payments made to date of approximately $300 million, primarily for administrative expenses and legal fees.

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

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 brought on behalf of all governmental entities, agencies, and political subdivisions of the State of California that indirectly purchased our operating system or word processing and spreadsheet software during the period from February 18, 1995 to the date of trial in the action. The plaintiffs seek 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 in its entirety 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. Microsoft and the plaintiffs have entered into a tentative settlement of this case. The settlement has been approved by all named plaintiffs and the parties are finalizing language for the settlement agreement. If approved by the court, this settlement will resolve all claims asserted in the lawsuit.

OnIn November 12, 2004, Novell, Inc. filed a complaint in the U.S. District Court for Utah, now consolidated with other cases in 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. OnIn June 10, 2005, the trial court granted our motion to dismiss four of six claims of the complaint. The remaining two claims were not dismissedAn appeal of that ruling is now pending and litigation has proceeded on those claims. We are seeking leave to appeal the decision not to dismiss those claims.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 onin 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. OnIn 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 onin March 2, 2005 the U.S. Court of Appeals for the Federal Circuit reversed the decision and vacated the judgment, ruling thatbased on certain evidentiary rulings of the trial court had erred in excluding certain previous art evidence and ruling as a matter of law on other evidence.court. 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.conduct. 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. InResearch Corporation Technologies, Inc. v. Microsoft, filed in U.S. District Court for the District of Arizona on December 21, 2001, the plaintiff has asserted three patents related to half-toning, which it believes are infringed by certain printing functionality allegedly present in different versions of Windows. Plaintiff seeks unspecified “reasonable royalties” on Microsoft’s Windows products. Microsoft’s defense based on the plaintiff’s inequitable conduct was tried in August 2005. In November 2005, the court announced its finding that the inventors engaged in inequitable conduct and that the patents are therefore unenforceable against Microsoft. We are awaiting the court’s written decision, and anticipate the plaintiff will appeal. InMicrosoft v. Lucent, filed in the U.S. District Court in San Diego onin 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 Microsoft our

software pre-installed. No trial date has been set. InArendi USA, Inc. and Arendi Holding Limited v. Microsoft,The first in a series of back-to-back trials on the various patent groupings is currently set

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NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

to begin in January 2007. In March 2006, Lucent filed a new lawsuit against us in U.S. District Court forin San Diego, claiming the District of Rhode Island on July 31, 2002, the plaintiffs alleged infringement ofXbox 360 violates one patent by certain Smart Tags features in Microsoft Office XP and Office 2003. Following trial in September 2004 the jury returned a verdict for us, finding that we did not infringe the patents. The plaintiffs have appealed. Similarly, inSpacone v. Microsoft, the plaintiff asserts that Smart Tags features in Microsoft Word and Excel violate patent rights of the bankrupt At Home Corporation. A summary judgment hearing took place in January 2006 and trial is set for May.patents that earlier had been dismissed from the older lawsuit. InAmado v. Microsoft, filed in U.S. District Court for the Central District of California on March 7, 2003, the plaintiff has accused the link table functionality available in Microsoft Access when used with Microsoft Excel. After a jury trial, response to Lucent’s new complaint, we were found to infringe one claim of theasserted patent and damages were awarded in the amount of $8.9 million. 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 distribution of the accused feature as part of Microsoft Access, but stayed the injunction pending appellate review. We have appealed. InBTG v. Microsoft, filed in U.S. District Court for the Northern District of California on July 2, 2004, the plaintiff has accused our Windows and Office productsinfringement counterclaims accusing Lucent of infringing several patents. The10 Microsoft patents are directed to “update” technology, active desktop concepts, and offline browsing.by its sales of various products. No trial date has been set.set in the new lawsuit. InZ4 Technologies, Inc. v. Microsoft,, the plaintiff allegesalleged that Microsoft Windows and Office product activation functionality violates its patent rights. Trial is scheduled forIn April 2006, the jury rendered a $115 million verdict against us. In August 2006, the trial court increased damages by $25 million pursuant to the jury’s finding of willful infringement and awarded Z4 $2 million in federal district courtattorneys’ fees. We intend to appeal the verdict. InVeritas Operating Corporation v. Microsoft, filed in Texas. A software company has discussed with usthe U.S. District Court for the Western District of Washington in May 2006, a subsidiary of Symantec filed an action asserting claims of trade secret misappropriation, breach of contract, and patent infringement. These claims primarily relateinfringement relating to certain functionality in our server operating system products but also impact our desktop operating systems.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 that would adversely affectingaffect distribution of our operating system or application products. The risks associated with an adverse decision may result in material settlements.

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. WhileAlthough management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact on our financial position, or our results of operations, or our cash flows, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future.

As of September 30, 2006, we had accrued aggregate liabilities totaling $1.0 billion in other current liabilities and $0.8 billion 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 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 ourthe Company’s financial position and on the results of operations for the period in which the effect becomes reasonably estimable.

As of December 31, 2005, we had accrued aggregate liabilities totaling $0.6 billion in other current liabilities and $1.0 billion in other long-term liabilities for all of the contingent matters described in this note.

Note 98 – Segment Information

SFAS No. 131,Disclosures about Segments of an Enterprise and Related Information, 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 run the business, including internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. In September 2005,Effective July 1, 2006, we announced a plan to reorganize the companyreorganized our business into five operating segments, organized under one of three newly formedoperating divisions – Microsoft Platform ProductsPlatforms and Services Division, Microsoft Business Division, and Microsoft Entertainment and Devices Division.

The operationalfive operating segments are described below. The first three of these comprise the Platforms and internal reporting impactsServices Division.

Client includes the former Client segment. Client generates nearly all of its revenue from the licensing of the planned reorganization are currently being evaluated.Windows line of operating systems, including Windows XP Professional and Home, Media Center Edition, Tablet PC Edition, and other standard Windows operating systems.

Server and Tools includes the former Server and Tools segment, excluding Exchange Server, Exchange client access licenses and a portion of Core client access licenses which now reside in the Microsoft Business

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Division. Server and Tools generates revenues from the following products: Windows Server operating system, Microsoft SQL Server, Visual Studio, System Center products, Forefront security family of products and Biz Talk Server among others. In addition, Server and Tools provides the following services: Microsoft Consulting Services; Premier; and professional support services.

Online Services Business (“OSB”) includes the former MSN segment and Windows Live. OSB derives its revenue principally through the delivery of advertising and paid search. OSB also generates services revenue through providing the following online offerings: MSN Internet Access; MSN Premium Web Services (consisting of MSN Internet Software Subscriptions, MSN Hotmail Plus, MSN Bill Pay, and MSN Radio Plus); and MSN Mobile Services.

Microsoft Business Division (“MBD”) includes the former Information Worker and Microsoft Business Solutions segments, and the Exchange Server business and certain client access licenses formerly included in the Server and Tools segment. MBD derives its revenues principally through the Microsoft Office System which includes: Microsoft Office, Microsoft Project; Microsoft Visio; Microsoft Access; SharePoint Portal Server client access licenses; OneNote; Office Communication Server; Microsoft Office Small Business Accounting; and services revenues generated by Microsoft LiveMeeting. Product revenues are also derived through the licensing of the Dynamics suite of software including: Microsoft Dynamics AX; Microsoft Dynamics CRM; Microsoft Dynamics GP; Microsoft Dynamics NAV; Microsoft Dynamics SL; and Microsoft Dynamics Retail Management System.

Entertainment and Devices Division (“EDD”) includes the former Home and Entertainment and Mobile and Embedded Devices segments. EDD generates product revenues through both hardware and software sales and licensing. The Xbox 360 console generates the majority of hardware revenue with the remainder driven by consumer peripherals and accessories. Software revenues are generated by Xbox games; games for Windows; Mac Office; MSTV Platforms; Windows Mobile software platform and Windows Embedded device operating system. Online services revenues are generated by certain product support and Xbox Live.

Segment revenue and operating income/(loss) iswas as follows (1):