UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the Quarterly Period Ended September 30, 20062007

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 September 30, 20062007

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

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 and Recent Accounting Pronouncements

Basis of Presentation

In the opinion of management, the accompanying balance sheets and related interim statements of income, cash flows, and stockholders’ equity include all adjustments, consisting only of normal recurring items, necessary for their fair presentation in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”). Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples includeinclude: estimates of loss contingencies, product warranties, product life cycles, product returns, 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; 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.

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 theretoinformation included in the Microsoft Corporation 20062007 Form 10-K.

As 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 period segment information to conform to the current period presentation. There was no impact on 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 and which do not have readily determinable fair values are accounted for under the cost method.

Recent Accounting Pronouncements

On July 1, 2007, we adopted the provisions of the Financial Accounting Standards Board (“FASB”) Interpretation No. 48 (“FIN 48”),Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109,which provides a financial statement recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. 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 13 – Income Taxes.

On July 1, 2007, we adopted the 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

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

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.

In February 2007, the FASB issued Statement of Financial Accounting Standards (“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, although early adoption is permitted. We are currently assessing the potential impact that electing fair value measurement would have 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. SFAS No. 157 is effective for us beginning July 1, 2008. We are currently assessing the potential impact that adoption of this statement would have on our financial statements.

Note 2 – Inventories net

Components of inventories were 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 were as follows:

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

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.

Note 4 – Unearned Revenue

ComponentsThe components of unearned revenue were as follows:

Unearned revenue by segment was as follows:

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Note 5 – Stockholders’ Equity

Share Repurchases

On July 20, 2006, we announced that our Board of Directors authorized two new share repurchase programs: a $20$20.0 billion tender offer whichthat 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 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$20.0 billion ongoing share repurchase program had been increased by approximately $16.2 billion. As a result, we are authorized to repurchase additional shares in an amount up to $36.2 billion through June 30, 2011. As of September 30, 2006,2007, approximately $35.3$12.8 billion remained of the $36.2 billion approved repurchase amount. All repurchases were made using cash resources. The repurchase program may be suspended or discontinued at any time without notice. In any period, cash used in financing

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

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 plans:

Dividends

On September 13, 2006, ourOur 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.following dividends:

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. The ex-dividend date was November 15, 2005.

Declaration Date		Per Share Dividend			Record Date		Total Amount				Payment Date
							(in millions)
(Fiscal year 2008)
September 12, 2007		$	0.11		November 15, 2007		$	1,029	(1)		December 13, 2007
(Fiscal year 2007)
September 13, 2006		$	0.10		November 16, 2006		$	980			December 14, 2006

(1)

This dividend was included in other current liabilities on our balance sheet as of September 30, 2007.

Note 6 – Investment Income and Other

Components of investment income and other were as follows:

Note 7 – Product Warranties

We provide for the estimated costs of hardware and software warranties at the time the related revenue is recognized. For hardware warranty, we estimate the costs based on historical and projected product failure rates, historical and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and country in which we do business, but generally include technical support, parts, and labor over a period generally ranging from 90 days to three years. For software warranty, we estimate the costs to provide bug fixes, such as security patches, over the estimated life of the software.

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

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

Note 78 – Contingencies

Government competition law matters.In March 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 providelicense to our competitors with licenses to certain protocol technology in the Windows server operating

systems and by including streaming media playback functionalityfeatures in Windows desktop operating systems. The Commission ordered us to makelicense the relevant licenses to ourprotocol 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.playback software. The decisionCommission also imposed a fine offined us €497 million ($605 million). We appealed the decision to the Court of First Instance, on the basis that we did not infringe European competition law.Instance. In July 2006, the European Commission announced its determinationdetermined that we had not complied with the technical documentation requirements of the 2004 Decision, and levied a fine offined us €281 million ($351 million). We have appealed this fine to the Court of First Instance.

We have expensed and paid both fines, pending resolution of appeals. In March 2007, the European Commission announced a new statement of objections. The new statement of objections claims that the pricing terms we proposed for licensing certain server protocol technology as required by the March 2004 decision are “not reasonable.” The statement of objections threatens to impose new fines of up to €500,000 ($706,075) per day from December 2005 to June 2006, up to €2 million ($2.8 million) per day from June to July 2006, and up to €3 million ($4.2 million) per day beginning August 2006. The maximum amount of the potential fine as of October 22, 2007 is $2.1 billion. On September 17, 2007, the Court of First Instance affirmed the European Commission’s 2004 decision in almost all respects. On October 22, 2007, following discussions between the Commission and Microsoft, the Commission announced that steps we had taken brought us into full compliance with the March 2004 Decision. We announced the same day that we would not appeal the decision of the Court of First Instance to the European Court of Justice. On October 24, 2007, we announced that we had discontinued our appeals of two other Commission decisions, including the July 2006 Decision imposing a fine.

In December 2005, the Korean Fair Trade Commission (“KFTC”) announced a ruling in its investigation of us, holdingruled that we abused a market dominant position and engaged in unfair trade practices under the Korean Fair Trade Act. The KFTC stated we violated the Act by incorporatingbuilding instant messaging and media player functionalityfeatures into the Windows PC operating system and streaming media technologies into the Windows server operating system. The KFTC also imposed a fine of approximately $34 million.million which we have expensed and paid. The KFTC’s ruling and corrective order issued in February 2006 held that our integration of Windows Media Playerthese media and Windows Messenger inmessaging features into the Windows PC operating systems and integration of Windows Media Services in Windows server operating systems constitutedwas an abuse of monopoly power and unlawful tying in violation of the Korean Fair Trade Act. Under theThe order which became effective in August 2006, we are required us 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, weWe also may distribute a second modified version of Windows that contains the removed functionality, provided the second versionmedia and messenger features, as long as it includes promotional links in the user interface that will enable consumers to link to and download a select group ofcertain competing media players and instant messengers. We have appealed the KFTC’s decision to the Seoul 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 Playermedia player or Windows Messenger, or any feature with similarinstant messaging functionality in any product other than

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

the Windows client operating system for which we have a 50% or greater market share. On August 23, 2006,In October 2007, we announcedsubmitted a request to the releaseSeoul High Court to manufacturewithdraw our appeal of the mandated versionsruling, which was approved by the court and ends the litigation.

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 XP Home Editionoperating system businesses. Portions of the Consent Decree are scheduled to expire in November 2007 and Windows XP Professional Edition.

we voluntarily agreed to extend expiration of other elements of the Consent Decree to November 2009. On October 16, 2007, some states filed a motion with the U.S. District Court for the District of Columbia seeking to have most of the provisions of the Final Judgment in the action to which they are party extended for five years. This motion is pending. On October 19, 2007, the U.S. Department of Justice and other states advised the Court that they will not seek any extension of the Final Judgments to which they are party.

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 federalCanadian courts on behalf of variously definedvarious classes of direct and indirect purchasers of our PC operating system and certain other 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 allWe obtained dismissals of damages claims for damages in cases brought against us byof indirect purchasers under federal law and in 1815 states. Ten of those state court decisions have been affirmed on appeal. There was no appeal in five states. In addition, courts in two statesCourts refused to certify classes essentially bringing the litigation to a close. Claims under federal law brought on behalf of foreign purchasersin two additional states. We 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 U.S.

Court of Appeals for the Fourth Circuit, together 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 18 states have ruled that indirect purchaser cases may proceed as class actions. In 2003, we reached an agreement with counsel for the California plaintiffsagreements to settle all claims that have been made to date in 27 consolidated cases in that state. 19 states.

Under the settlement,settlements, generally class members will be able tocan obtain vouchers that entitle

the class members them 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 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 a claimclaims 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 $2.5$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 whothat 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 Virginiaall states have received final court approval. SettlementsCases in ArkansasArizona, Mississippi and WisconsinCanada have received preliminary court approval. In Iowa, a jury trial on the plaintiffs’ claims is scheduled to begin in November 2006.not been settled. We estimate the total cost to resolve all of these cases will range between $1.5$1.7 billion and $1.8 billion, with the$1.9 billion. The actual cost dependent upon many unknowndepends 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 process. In accordance with SFAS No. 5,Accounting for Contingencies, and FIN No. 14,Reasonable Estimation of the Amount of a Loss,atclaims. At September 30, 2006,2007, we have recorded a liability related to these claims of approximately $1.2$1.0 billion, which reflects our estimated exposure of $1.5$1.7 billion less payments made to date of approximately $300$626 million, primarilymostly for administrative expenses and legal fees.

Other antitrust litigation and claims. In November 2004, Novell, Inc. filed a complaint in the U.S. District Court forin 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. In June 2005, the trial court granted our motion to dismiss four of six claims of the complaint. An appealBoth parties appealed, and in October 2007, the court of that ruling is now pending andappeals affirmed the decision of the trial court, remanding the case is effectively stayed during the appeal.to that court for further proceedings.

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Patent and intellectual property claims. We are a defendant invigorously defending more than 3545 patent infringement cases that we are defending vigorously.cases. In the case ofEolas Technologies, Inc. and University of California v. Microsoft,, filed in the U.S. District Court for the Northern District ofin Illinois in February 1999, the plaintiffs alleged infringement by the browser functionality of Windows. In January 2004, the trial court entered final judgment of $565 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 in March 2005 the U.S. Court of Appeals for the Federal Circuit reversed the decision and vacated the judgment, based on certain evidentiary rulings of the trial court. The appellate court also reversed the trial court’s decision that the inventors had not engaged in inequitable conduct. We believeThe parties have agreed to a settlement pursuant to which Microsoft has taken a license to the total costEolas patents. The settlement did not have a significant financial statement impact.

Microsoft and Alcatel-Lucent Matters. Microsoft and Alcatel-Lucent are parties to resolve this case will not be materiala number of legal proceedings relating to our financial position or resultscertain patents of operations. The actual costs will be dependent upon many unknown factors such as the events of a retrialeach of the plaintiff’s claims. companies. Some of these actions began before the merger of Alcatel and Lucent in 2006. For simplicity, we refer to the post-merger entity of Alcatel-Lucent throughout the following discussion.

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.

InZ4 Technologies, Inc. v. Microsoft, filed in U.S. District Court in Texas in September 2004, the plaintiff alleged that Microsoft Windows and Office product activation functionality violates its patent rights. In April

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

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 attorneys’ fees. We intend to appealhave appealed the verdict.

InVeritas Operating Corporation v. Microsoft, filed in the U.S. District Court for the Western District ofin Washington in May 2006, a subsidiary of Symantec filed an action asserting claims of trade secret misappropriation, breach of contract, and patent infringement relating to certain storage technologies. The case is scheduled for trial in May 2008.

Adverse outcomes in some or all of the matters described in this paragraphsection may result in significant monetary damages or injunctive relief against us that would adversely affect distribution of our operating system or application products. The risks associated with an adverse decisionWe may result inenter into material settlements.

settlements because of these risks.

Other. We are also subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact on our financial position, our results of operations, or our cash flows, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future.

As of September 30, 2006,2007, we had accrued aggregate liabilities totaling $1.0 billionof approximately $700 million in other current liabilities and $0.8 billionapproximately $650 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 whichthat we estimate could be up to $1.0$4.1 billion in aggregate beyond recorded amounts. Were an unfavorable final outcomeoutcomes to occur, there exists the possibility of a material adverse impact on the Company’sour financial position and on the results of operations for the period in which the effect becomeseffects become reasonably estimable.

Note 89 – Segment Information

SFAS No. 131,Disclosures about Segments of an Enterprise and Related Information, establishes standards for reporting information about operating segments. This standard requires segmentation based on our internal organization and reporting of revenue and operating income based upon internal accounting methods. Our financial reporting systems present various data for management to runoperate the business, including internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. Effective July 1, 2006, we reorganizedThe segments are designed to allocate resources internally and provide a framework to determine management responsibility. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is our business intoChief Executive Officer. Our five operating segments organized under one of three operating divisions – Platformsare Client; Server and Tools; Online Services Division,Business; Microsoft Business Division,Division; and Entertainment and Devices Division.

The five operating segments are described below. The first three of these comprise We have recast certain prior period amounts to conform to the Platformsway we internally manage and Services Division.

Client includesmonitor performance at the former Client segment. Client generates nearly all of its revenue from the licensing of the 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 residelevel in the Microsoft Businessfiscal year 2008.

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) was as follows (1):follows:

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

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. IntersegmentInter-segment cost commissions are estimated by management and used to compensate or charge each segment for such shared costs and to incent shared efforts.

Management will continually evaluate the alignment of product development organizations, sales organizations, and inter-segment commissions for segment reporting purposes, which may result in changes to segment allocations in future periods.

Reconciling amounts include adjustments to conform significant internal accounting policies with U.S. GAAP and corporate-level activity not specifically attributed to a segment. CertainSignificant internal accounting policies that differ from U.S. GAAP relate to revenue recognition, income statement classification, and accelerated amortization for depreciation, stock awards, and performance-based stock awards. In addition, certain revenue and expenses including legal settlements and legal contingencies, are excluded from segments or included in corporate-level activity. activity, including certain legal settlements and accruals for legal contingencies.

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Significant reconciling items to arrive at operating income were as follows:

Note 10 – Acquisitions

On August 10, 2007, we acquired all of the outstanding shares of aQuantive, Inc. for $5.9 billion which was paid primarily in cash. Headquartered in Seattle, Washington, aQuantive is a digital marketing company which we expect will play a key role in the future development of our advertising 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, Inc. was consolidated into our results of operations starting August 10, 2007, the acquisition date.

The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of the acquisition:

As a result of this acquisition, we recorded $5.3 billion of goodwill in our Online Services Business operating segment. Of the $938 million of acquired intangible assets, $24 million was assigned to in-process

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

research and development assets and was expensed during the quarter. 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 useful life of four years, and $111 million of other intangible assets with a weighted average life of five years.

In addition to aQuantive, we acquired four other entities during the three months ended September 30, 2007 for total consideration of $147 million which was paid primarily in cash. All of the entities were consolidated within Microsoft starting on their respective acquisition dates. Pro forma results of operations have not been presented because the effects of these acquisitions, individually and in aggregate, were not material to our consolidated results of operations.

Note 911 – Goodwill

During the three months ended September 30, 2006,2007, we recorded $5.4 billion of goodwill resulting from the following acquisitions: Softricity, Inc. ($179 million); Whale Communications Ltd. ($66 million); Winternals Software LP ($31 million); and others ($19 million). Allfive acquisitions described in Note 10 – Acquisitions. None of the amount recorded as goodwill was assignedis expected to our Server and Tools operating segment. All of the entities were consolidated with Microsoft since their respective acquisition dates.be deductible for tax purposes. The purchase price allocationsallocation for theseall of the acquisitions areis preliminary and subject to revision as more detailed analyses are completed and additional information about fair value of assets and liabilities becomesbecome available. Any change in the fair value of the net assets of the acquired companiescompany will change the amount of the purchase price allocable to goodwill. Pro forma

Note 12 – Intangible Assets

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

Acquired intangibles are generally amortized on a straight-line basis over their weighted average lives. Intangible assets amortization expense was $102 million for the quarter ended September 30, 2007 and $38

MICROSOFT CORPORATION

NOTES TO FINANCIAL STATEMENTS—(Continued)

(Unaudited)

million for the quarter ended September 30, 2006. The estimated future amortization expense related to intangible assets as of September 30, 2007 is expected to be $335 million for the remainder of fiscal year 2008, $422 million for fiscal year 2009, $373 million for fiscal year 2010, $296 million for fiscal year 2011, and $292 million for fiscal year 2012 and thereafter.

Note 13 – Income Taxes

On July 1, 2007, we adopted the provisions of 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.

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 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. As of July 1, 2007 we had accrued interest related to uncertain tax positions of $863 million, net of federal income tax benefit, on our balance sheet.

We are currently under audit by the IRS for tax years 2000 through 2006. While it is possible that the first audit cycle, 2000 through 2003, may conclude in the next 12 months and that the unrecognized tax benefits we have recorded in relation to this audit may change compared to the liabilities recorded for the period, it is not possible to estimate the effect, if any, of any amount of such change during the next 12 months to previously recorded uncertain tax positions.

We are subject to income tax in many jurisdictions outside the United States, none of which are individually material to our financial position, statement of cash flows, or results of operations have not been presented because the effects of these acquisitions, individually and in the aggregate, were not material.operations.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To The Board of Directors and Stockholders of

Microsoft Corporation

Redmond, Washington

We have reviewed the accompanying consolidated balance sheet of Microsoft Corporation and subsidiaries (the “Corporation”) as of September 30, 2006,2007, and the related consolidated statements of income, stockholders’ equity, and cash flows for the three-month periods ended September 30, 20062007 and 2005.2006. These interim financial statements are the responsibility of the Corporation’s management.

We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to such consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Microsoft Corporation and subsidiaries as of June 30, 2006,2007, and the related consolidated statements of income, stockholders’ equity, and cash flows for the year then ended (not presented herein); and in our report dated August 22, 2006,3, 2007, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of June 30, 20062007 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

DELOITTE & TOUCHE LLP

/S/    DELOITTE & TOUCHE LLP

Seattle, Washington

October 25, 2007

/s/    DELOITTE & TOUCHE LLP                                    

Seattle, Washington

October 24, 2006

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Special Note About Forward-Looking Statements

Certain statements in Management’s Discussion and Analysis (“MD&A”), other than purely historical information, including estimates, projections, statements relating to our business plans, objectives and expected operating results, and the assumptions upon which those statements are based, are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially from the 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 II, Item 1A). We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events, or otherwise.

OVERVIEW

The following 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, and support a wide range of software products for many computing devices. Our software products include operating systems for servers, PCs, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutions applications; and software development tools. We provide consulting and product support services, and we train and certify system integrators and developers. We sell the Xbox video game console and games, the Zune digital music and entertainment device, PC games, and PC peripherals. Online communication and information services are delivered through our MSN portals, and channels around the world.

world, and through our search products.

Our revenue historically has fluctuated quarterly and has generally been the highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers. Our Entertainment and Devices Division is particularly subject to seasonalityseasonal as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Typically, the Entertainment and Devices Division has generated over 40% of its yearly segment revenues in our second fiscal quarter. We believeIn fiscal year 2007, our revenue was highest in the seasonalitythird quarter due to the recognition of $1.7 billion of revenue is likely to continue in the future.

Summary

Our revenue increase for the three months ended September 30, 2006 was driven primarily by sales of Xbox 360, which was launched in November 2005, and increased licensing of SQL Server, Windows Server, and Visual Studio. Also contributing to the increase in revenue was growth in licensing of Windows Client operating systems as a result of overall growth in the PC market and increased licensing of Office. Based on our

preliminary estimates, total worldwide PC shipments from all sources grew 8% to 10%previously deferred from the first quarter of fiscal year 2006, driven by strong consumer demand in both emerging and mature markets. Overall server hardware shipments growth in the first quarter was consistent with our full year estimate of 10% to 12%.

For the three months ended September 30, 2006, operating income increased primarily reflecting the revenue increase and a $362 million decrease in costs for legal settlements and legal contingencies. The increase in Entertainment and Devices revenue was partially offset by an increase in cost of revenue primarily related to the shift in product mix from the first generation Xbox to Xbox 360. Additionally, continued investments in our Online Services Business increased our cost of revenue in that segment. Finally, headcount-related costs and research and development expenses increased as we continue to invest in our new and upcoming offerings such as our Windows Live platform, Windows Vista, the 2007 Microsoft Office system, Unified Communications, and Zune, our upcoming digital music and entertainment device. Headcount-related costs, including stock-based compensation expense, increased 21%, resulting from both an increase in salaries and benefits for existing headcount and a 17% increase in headcount over the past 12 months.

For the remainder of the fiscal year, we expect revenue to grow at a higher rate than fiscal year 2006, mainly reflecting significant product launches in fiscal year 2007. In October 2006, we announced our Express Upgrade to Windows Vista and Microsoft Office Technology Guarantee programs which provide consumersand pre-shipments of Windows Vista and the 2007 Microsoft Office system. The technology guarantee programs provided customers who purchasepurchased current products during the holiday season with free or discounted rights to Windows Vista and the 2007 Microsoft Office Systemsystem when those products become available. As a result, a material amountbecame available to consumers. We believe the seasonality of revenue is expectedlikely to be deferred fromcontinue in the second quarterfuture consistent with our experience prior to fiscal year 2007.

All growth and percentage comparisons refer to the third quarterthree months ended September 30, 2007 as compared to the three months ended September 30, 2006 unless otherwise noted.

Summary

Revenue growth was driven primarily by increased Xbox console and game sales, licensing of Windows Vista and the 2007 Microsoft Office system, and increased revenue associated with Windows Server and SQL Server. Revenue from licensing of Windows Vista and the 2007 Microsoft Office system reflects growth in our OEM channel and growth from Enterprise Agreement licenses. Foreign currency exchange rates accounted for a $205 million or two percentage point increase in revenue during the quarter.

Operating income growth was driven primarily by the increased revenue, partially offset by increased Xbox 360 product costs, warranty expenses, and inventory write-downs; data center costs in our Online Services Business; increased Windows Vista product costs; and increased sales and marketing expenses. The increase in sales and marketing expenses was primarily driven by increased headcount-related expenses and marketing costs related to corporate events and our retail channel. Total headcount-related expenses increased 6%, driven by a 12% increase in headcount over the past twelve months and an increase in salaries and benefits for existing headcount, partially offset by decreased stock-based compensation expense.

Worldwide macroeconomic factors have a strong correlation to business and consumer demand for our software, services, games, and Internet service offerings. We expect a broad continuation of economic conditions and demand during the remainder of fiscal year 2007. The amount to be deferred will depend on the level and timing of sales, and the2008. We also expect continued double digit revenue growth. Given our product and channel mix. Because the programs are expected to concludelaunches in the third quartersecond half of fiscal year 2007, we do not expect revenue growth to be higher in the programs to adversely affect ourfirst half of fiscal year 2007 revenue.

2008 than in the second half. We estimate worldwide PC shipments will continue to grow 8% tobetween 10% and overall server hardware shipments will continue to grow 10% to 12%. We expect a continued favorable impact from changes in year-over-year foreign currency exchange rates in fiscal year 2007.

2008. We expect our operating income growth rate in fiscal year 2007 will lag behindto continue to exceed our revenue growth rate. We expect our level of spending to increase in four key areas in fiscal year 2007: increased product costs associated with Xbox consoles; marketing and field sales spending including product launch costs; quickening the pace of development in growth areas such as business intelligence, security, management and unified communications (including through acquisitions); and increased costs to execute on our online services strategy. While these investments will translate into increased operating expenses, we believe they will help lay the groundwork for future growth and profitability.

SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS)

Revenue and operating income/(loss) amounts in this section are presented on a basis consistent with U.S. GAAP and include certain reconciling items attributable to each of the segments. Segment information appearing in Note 89 – Segment Information of the Notes is presented on a basis consistent with the Company’sour current internal management reporting, in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 131,Disclosures about Segments of an Enterprise and Related Information. Certain corporate-level activity has been excluded from segment operating results and is presentedanalyzed separately. Prior period amounts have been recast to conform to the way we internally manage and monitor performance at the segment level in fiscal year 2008.

Client