Exhibit 13.4
Microsoft Corporation
Financial Statements
Income Statements for the three years ended June 30, 2000
Cash Flows Statements for the three years ended June 30, 2000
Balance Sheets as of June 30, 1999 and 2000
Stockholders' Equity Statements for the three years ended June 30, 2000
Notes to Financial Statements
Independent Auditors' Report
1
Income Statements
(In millions, except earnings per share)
- -------------------------------------------------------------------------------------------------------------
Year Ended June 30 1998 1999 2000
- -------------------------------------------------------------------------------------------------------------
Revenue $15,262 $19,747 $22,956
Operating expenses:
Cost of revenue 2,460 2,814 3,002
Research and development 2,601 2,970 3,775
Acquired in-process technology 296 -- --
Sales and marketing 2,828 3,231 4,141
General and administrative 433 689 1,009
Other expenses 230 115 92
- -------------------------------------------------------------------------------------------------------------
Total operating expenses 8,848 9,819 12,019
- -------------------------------------------------------------------------------------------------------------
Operating income 6,414 9,928 10,937
Investment income 703 1,803 3,182
Gain on sales -- 160 156
- -------------------------------------------------------------------------------------------------------------
Income before income taxes 7,117 11,891 14,275
Provision for income taxes 2,627 4,106 4,854
- -------------------------------------------------------------------------------------------------------------
Net income $ 4,490 $ 7,785 $ 9,421
=============================================================================================================
Earnings per share:
Basic $ 0.92 $ 1.54 $ 1.81
=============================================================================================================
Diluted $ 0.84 $ 1.42 $ 1.70
=============================================================================================================
See accompanying notes.
2
Cash Flows Statements
(In millions)
- ---------------------------------------------------------------------------------------------------------
Year Ended June 30 1998 1999 2000
- ---------------------------------------------------------------------------------------------------------
Operations
Net income $ 4,490 $ 7,785 $ 9,421
Depreciation, amortization, and other noncash items 1,024 926 748
Write-off of acquired in-process technology 296 -- --
Gain on sales -- (160) (156)
Stock option income tax benefits 1,553 3,107 5,535
Unearned revenue 3,268 5,877 6,177
Recognition of unearned revenue from prior periods (1,798) (4,526) (5,600)
Other current liabilities 208 1,050 (445)
Accounts receivable (520) (687) (944)
Other current assets (88) (235) (775)
- ---------------------------------------------------------------------------------------------------------
Net cash from operations 8,433 13,137 13,961
- ---------------------------------------------------------------------------------------------------------
Financing
Common stock issued 959 1,350 2,245
Common stock repurchased (2,468) (2,950) (4,896)
Put warrant proceeds 538 766 472
Preferred stock dividends (28) (28) (13)
- ---------------------------------------------------------------------------------------------------------
Net cash used for financing (999) (862) (2,192)
- ---------------------------------------------------------------------------------------------------------
Investing
Additions to property and equipment (656) (583) (879)
Cash portion of WebTV purchase price (190) -- --
Cash proceeds from sale of Softimage, Inc. -- 79 --
Purchases of investments (19,114) (36,441) (43,158)
Maturities of investments 1,890 4,674 4,025
Sales of investments 10,798 21,080 28,085
- ---------------------------------------------------------------------------------------------------------
Net cash used for investing (7,272) (11,191) (11,927)
- ---------------------------------------------------------------------------------------------------------
Net change in cash and equivalents 162 1,084 (158)
Effect of exchange rates on cash and equivalents (29) 52 29
Cash and equivalents, beginning of year 3,706 3,839 4,975
- ---------------------------------------------------------------------------------------------------------
Cash and equivalents, end of year $ 3,839 $ 4,975 $ 4,846
=========================================================================================================
See accompanying notes.
3
Balance Sheets
(In millions)
- -------------------------------------------------------------------------------------------------------
June 30 1999 2000
- -------------------------------------------------------------------------------------------------------
Assets
Current assets:
Cash and equivalents $ 4,975 $ 4,846
Short-term investments 12,261 18,952
- -------------------------------------------------------------------------------------------------------
Total cash and short-term investments 17,236 23,798
Accounts receivable 2,245 3,250
Deferred income taxes 1,469 1,708
Other 752 1,552
- -------------------------------------------------------------------------------------------------------
Total current assets 21,702 30,308
Property and equipment, net 1,611 1,903
Equity and other investments 14,372 17,726
Other assets 940 2,213
- -------------------------------------------------------------------------------------------------------
Total assets $38,625 $52,150
=======================================================================================================
Liabilities and stockholders' equity
Current liabilities:
Accounts payable $ 874 $ 1,083
Accrued compensation 396 557
Income taxes 1,691 585
Unearned revenue 4,239 4,816
Other 1,602 2,714
- -------------------------------------------------------------------------------------------------------
Total current liabilities 8,802 9,755
- -------------------------------------------------------------------------------------------------------
Deferred income taxes 1,385 1,027
Commitments and contingencies
Stockholders' equity:
Convertible preferred stock--shares authorized 100;
shares issued and outstanding 13 and 0 980 --
Common stock and paid-in capital--shares authorized 12,000;
shares issued and outstanding 5,109 and 5,283 13,844 23,195
Retained earnings, including other comprehensive income
of $1,787 and $1,527 13,614 18,173
- -------------------------------------------------------------------------------------------------------
Total stockholders' equity 28,438 41,368
- -------------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity $38,625 $52,150
=======================================================================================================
See accompanying notes.
4
Stockholders' Equity Statements
(In millions)
- ------------------------------------------------------------------------------------------------------
Year Ended June 30 1998 1999 2000
- ------------------------------------------------------------------------------------------------------
Convertible preferred stock
Balance, beginning of year $ 980 $ 980 $ 980
Conversion of preferred to common stock -- -- (980)
- ------------------------------------------------------------------------------------------------------
Balance, end of year 980 980 --
- ------------------------------------------------------------------------------------------------------
Common stock and paid-in capital
Balance, beginning of year 4,509 8,025 13,844
Common stock issued 1,262 2,338 3,554
Common stock repurchased (165) (64) (210)
Structured repurchases price differential 328 (328) --
Proceeds from sale of put warrants 538 766 472
Stock option income tax benefits 1,553 3,107 5,535
- ------------------------------------------------------------------------------------------------------
Balance, end of year 8,025 13,844 23,195
- ------------------------------------------------------------------------------------------------------
Retained earnings
Balance, beginning of year 5,288 7,622 13,614
- ------------------------------------------------------------------------------------------------------
Net income 4,490 7,785 9,421
Other comprehensive income:
Net unrealized investment gains/(losses) 627 1,052 (283)
Translation adjustments and other (124) 69 23
- ------------------------------------------------------------------------------------------------------
Comprehensive income 4,993 8,906 9,161
Preferred stock dividends (28) (28) (13)
Immaterial pooling of interests -- -- 97
Common stock repurchased (2,631) (2,886) (4,686)
- ------------------------------------------------------------------------------------------------------
Balance, end of year 7,622 13,614 18,173
- ------------------------------------------------------------------------------------------------------
Total stockholders' equity $16,627 $28,438 $41,368
======================================================================================================
See accompanying notes.
5
Notes to Financial Statements
Accounting Policies
Accounting Principles
The financial statements and accompanying notes are prepared in accordance with
generally accepted accounting principles in the United States.
Principles of Consolidation
The financial statements include the accounts of Microsoft and its subsidiaries.
Significant intercompany transactions and balances have been eliminated.
Investments in unconsolidated joint ventures are accounted for using the equity
method; the Company's share of joint ventures' activities is reflected in other
expenses.
Estimates and Assumptions
Preparing financial statements requires management to make estimates and
assumptions that affect the reported amounts of assets, liabilities, revenue,
and expenses. Examples include provisions for returns, concessions and bad
debts, and the length of product life cycles and buildings' lives. Actual
results may differ from these estimates.
Foreign Currencies
Assets and liabilities recorded in foreign currencies are translated at the
exchange rate on the balance sheet date. Translation adjustments resulting from
this process are charged or credited to other comprehensive income. Revenue and
expenses are translated at average rates of exchange prevailing during the year.
Gains and losses on foreign currency transactions are included in other
expenses.
Revenue Recognition
Revenue is recognized when earned. The Company's revenue recognition policies
are in compliance with all applicable accounting regulations, including American
Institute of Certified Public Accountants (AICPA) Statement of Position (SOP)
97-2, Software Revenue Recognition, and SOP 98-9, Modification of SOP 97-2, With
Respect to Certain Transactions. Revenue from products licensed to original
equipment manufacturers is recorded when OEMs ship licensed products while
revenue from certain license programs is recorded when the software has been
delivered and the customer is invoiced. Revenue from packaged product sales to
and through distributors and resellers is recorded when related products are
shipped. Maintenance and subscription revenue is recognized ratably over the
contract period. Revenue attributable to undelivered elements, including
technical support and Internet browser technologies, is based on the average
sales price of those elements and is recognized ratably on a straight-line basis
over the product's life cycle. When the revenue recognition criteria required
for distributor and reseller arrangements are not met, revenue is recognized as
payments are received. Costs related to insignificant obligations, which
include telephone support for certain products, are accrued. Provisions are
recorded for returns, concessions and bad debts.
Cost of Revenue
Cost of revenue includes direct costs to produce and distribute product and
direct costs to provide online services, consulting, product support, and
training and certification of system integrators.
Research and Development
Research and development costs are expensed as incurred. Statement of Financial
Accounting Standards (SFAS) 86, Accounting for the Costs of Computer Software to
Be Sold, Leased, or Otherwise Marketed, does not materially affect the Company.
Advertising Costs
Advertising costs are expensed as incurred. Advertising expense was $732
million in 1998, $804 million in 1999, and $1.1 billion in 2000.
Income Taxes
Income tax expense includes U.S. and international income taxes, plus the
provision for U.S. taxes on undistributed earnings of international
subsidiaries. Certain items of income and expense are not reported in tax
returns and financial statements in the same year. The tax effect of this
difference is reported as deferred income taxes.
Financial Instruments
The Company considers all liquid interest-earning investments with a maturity of
three months or less at the date of purchase to be cash equivalents. Short-term
investments generally mature between three months and six years from the
purchase date. All cash and short-term investments are classified as available
for sale and are recorded at market
6
using the specific identification method; unrealized gains and losses are
reflected in other comprehensive income. Cost approximates market for all
classifications of cash and short-term investments; realized and unrealized
gains and losses were not material.
Equity and other investments include debt and equity instruments. Debt
securities and publicly traded equity securities are classified as available for
sale and are recorded at market using the specific identification method.
Unrealized gains and losses are reflected in other comprehensive income. All
other investments, excluding joint venture arrangements, are recorded at cost.
Derivative financial instruments are used to hedge certain investments,
international revenue, accounts receivable, and interest rate risks, and are,
therefore, held primarily for purposes other than trading. These instruments
may involve elements of credit and market risk in excess of the amounts
recognized in the financial statements. The Company monitors its positions and
the credit quality of counter parties, consisting primarily of major financial
institutions, and does not anticipate nonperformance by any counter-party.
SFAS 133, Accounting for Derivative Instruments and Hedging Activities, as
amended by SFAS 137, Accounting for Derivative Instruments and Hedging
Activities - Deferral of the Effective Date of FASB Statement No. 133, and SFAS
138, Accounting for Certain Derivative Instruments and Certain Hedging
Activities, is effective for the Company as of July 1, 2000. SFAS 133 requires
that an entity recognize all derivatives as either assets or liabilities
measured at fair value. The accounting for changes in the fair value of a
derivative depends on the use of the derivative. Adoption of these new
accounting standards will result in cumulative after-tax reductions in net
income of approximately $350 million and other comprehensive income of
approximately $50 million in the first quarter of fiscal 2001. The adoption
will also impact assets and liabilities recorded on the balance sheet.
Property and Equipment
Property and equipment is stated at cost and depreciated using the straight-line
method over the shorter of the estimated life of the asset or the lease term,
ranging from one to 15 years. As required by SOP 98-1, Accounting for Costs of
Computer Software Developed or Obtained for Internal Use, Microsoft began
capitalizing certain computer software developed or obtained for internal use in
fiscal 2000. Capitalized computer software is depreciated using the straight-
line method over the shorter of the estimated life of the software or three
years.
Reclassifications
As required by Emerging Issues Task Force (EITF) Issue 00-15, Classification in
the Statement of Cash Flows of the Income Tax Benefit Received by a Company upon
Exercise of a Nonqualified Employee Stock Option, stock option income tax
benefits are classified as cash from operations in the cash flows statement.
Prior period cash flows statements have been restated to conform with this
presentation. Certain other reclassifications have been made for consistent
presentation.
Unearned Revenue
A portion of Microsoft's revenue is earned ratably over the product life cycle
or, in the case of subscriptions, over the period of the license agreement.
End users receive certain elements of the Company's products over a period of
time. These elements include items such as browser technologies and technical
support. Consequently, Microsoft's earned revenue reflects the recognition of
the fair value of these elements over the product's life cycle. Upon adoption
of SOP 98-9 during the fourth quarter of fiscal 1999, the Company was required
to change the methodology of attributing the fair value to undelivered elements.
The percentages of undelivered elements in relation to the total arrangement
decreased, reducing the amount of Windows and Office revenue treated as
unearned, and increasing the amount of revenue recognized upon shipment. The
percentage of revenue recognized ratably decreased from a range of 20% to 35% to
a range of approximately 15% to 25% of Windows desktop operating systems. For
desktop applications, the percentage decreased from approximately 20% to a range
of approximately 10% to 20%. The ranges depend on the terms and conditions of
the license and prices of the elements. In addition, in the fourth quarter of
fiscal 1999, the Company extended the life cycle of Windows from two to three
years based upon management's review of product shipment cycles. Product life
cycles are currently estimated at 18 months for desktop applications. The
Company also sells subscriptions to certain products via maintenance and certain
organizational license agreements. At June 30, 1999 and 2000, Windows Platforms
products unearned revenue was $2.17 billion and $2.61 billion and unearned
revenue associated with Productivity Applications and Developer products totaled
$1.96 billion and $1.99 billion. Unearned revenue for other miscellaneous
programs totaled $116 million and $210 million at June 30, 1999 and 2000.
7
Financial Risks
The Company's cash and short-term investment portfolio is diversified and
consists primarily of investment grade securities. Investments are held with
high-quality financial institutions, government and government agencies, and
corporations, thereby reducing credit risk concentrations. Interest rate
fluctuations impact the carrying value of the portfolio. The Company routinely
hedges the portfolio with options in the event of a catastrophic increase in
interest rates. The notional amount of the options outstanding was $4.0 billion
and $3.6 billion at June 30, 1999 and 2000. The fair value and premiums paid for
the options were not material. Much of the Company's equity security portfolio
is highly volatile, so certain positions are hedged.
Finished goods sales to international customers in Europe, Japan, Canada, and
Australia are primarily billed in local currencies. Payment cycles are
relatively short, generally less than 90 days. Certain international
manufacturing and operational costs are incurred in local currencies. Local
currency cash balances in excess of short-term operating needs are generally
converted into U.S. dollar cash and short-term investments on receipt. Although
foreign exchange rate fluctuations generally do not create a risk of material
balance sheet gains or losses, the Company hedges a portion of accounts
receivable balances denominated in local currencies, primarily with purchased
options. The notional amount of options outstanding was $662 million and $1.46
billion at June 30, 1999 and 2000. The fair value and premiums paid for the
options were not material.
Foreign exchange rates affect the translated results of operations of the
Company's foreign subsidiaries. The Company hedges a portion of planned
international revenue with purchased options. The notional amount of the
options outstanding was $2.25 billion and $2.08 billion at June 30, 1999 and
2000. The fair value and premiums paid for the options were not material.
At June 30, 1999 and 2000, approximately 50% and 42% of accounts receivable
represented amounts due from 10 customers. A single customer accounted for
approximately 8%, 11%, and 9% of revenue in 1998, 1999, and 2000.
Microsoft lends certain fixed income and equity securities to enhance investment
income. Collateral and/or security interest is determined based upon the
underlying security and the credit worthiness of the borrower.
Cash and Short-Term Investments
- ---------------------------------------------------------------
June 30 1999 2000
- ---------------------------------------------------------------
Cash and equivalents:
Cash $ 635 $ 849
Commercial paper 3,805 1,986
Certificates of deposit 522 1,017
U.S. government and agency securities -- 729
Corporate notes and bonds -- 265
Money market preferreds 13 --
- ---------------------------------------------------------------
Cash and equivalents 4,975 4,846
- ---------------------------------------------------------------
Short-term investments:
Commercial paper 1,026 612
U.S. government and agency securities 3,592 7,104
Corporate notes and bonds 6,996 9,473
Municipal securities 247 1,113
Certificates of deposit 400 650
- ---------------------------------------------------------------
Short-term investments 12,261 18,952
- ---------------------------------------------------------------
Cash and short-term investments $17,236 $23,798
===============================================================
8
Property and Equipment
- ----------------------------------------------------------------
June 30 1999 2000
- ----------------------------------------------------------------
Land $ 158 $ 176
Buildings 1,347 1,387
Computer equipment and software 1,433 1,909
Other 578 842
- ----------------------------------------------------------------
Property and equipment--at cost 3,516 4,314
Accumulated depreciation (1,905) (2,411)
- ----------------------------------------------------------------
Property and equipment--net $ 1,611 $ 1,903
================================================================
During 1998, 1999, and 2000, depreciation expense, of which the majority related
to computer equipment, was $528 million, $483 million, and $668 million;
disposals were not material.
Equity and Other Investments
- ---------------------------------------------------------------------------------------------------------------
Cost Unrealized Unrealized Recorded
June 30, 1999 Basis Gains Losses Basis
- ---------------------------------------------------------------------------------------------------------------
Debt securities recorded at market, maturing:
Within one year $ 682 $ 8 $ -- $ 690
Between 10 and 15 years 533 30 (33) 530
Beyond 15 years 4,731 347 -- 5,078
- ---------------------------------------------------------------------------------------------------------------
Debt securities recorded at market 5,946 385 (33) 6,298
- ---------------------------------------------------------------------------------------------------------------
Common stock and warrants 3,029 3,598 (799) 5,828
Preferred stock 2,179 -- -- 2,179
Other investments 67 -- -- 67
- ---------------------------------------------------------------------------------------------------------------
Equity and other investments $11,221 $3,983 $(832) $14,372
- ---------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------
Cost Unrealized Unrealized Recorded
June 30, 2000 Basis Gains Losses Basis
- ---------------------------------------------------------------------------------------------------------------
Debt securities recorded at market, maturing:
Within one year $ 498 $ 27 $ -- $ 525
Between 2 and 10 years 388 11 (3) 396
Between 10 and 15 years 775 14 (93) 696
Beyond 15 years 4,745 -- (933) 3,812
- ---------------------------------------------------------------------------------------------------------------
Debt securities recorded at market 6,406 52 (1,029) 5,429
- ---------------------------------------------------------------------------------------------------------------
Common stock and warrants 5,815 5,655 (1,697) 9,773
Preferred stock 2,319 -- -- 2,319
Other investments 205 -- -- 205
- ---------------------------------------------------------------------------------------------------------------
Equity and other investments $14,745 $5,707 $(2,726) $17,726
- ---------------------------------------------------------------------------------------------------------------
Debt securities include corporate and government notes and bonds and derivative
securities. Debt securities maturing beyond 15 years are composed entirely of
AT&T 5% convertible preferred debt with a contractual maturity of 30 years. The
debt is convertible into AT&T common stock on or after December 1, 2000, or may
be redeemed by AT&T upon satisfaction of certain conditions on or after June 1,
2002. Equity securities that are restricted for more than one year or not
publicly traded are recorded at cost. At June 30, 1999 and 2000, the estimated
fair value of these investments in excess of their recorded basis was $2.3
billion and $2.7 billion, based on publicly available market information or
other estimates determined by management. The Company hedges the risk of
significant market declines on certain highly volatile equity securities with
options. The options are recorded at market, consistent with the underlying
equity securities. At June 30, 1999 and 2000, the notional amount of the
options outstanding was $2.1 billion and $4.0 billion; the fair value represents
obligations of $1.0 billion and $1.7 billion; and premiums paid for the options
were not material. Realized gains and losses of equity and other investments in
1998 were not material; realized gains were $623 million and $1.7 billion in
1999 and 2000 and losses were not material in 1999 and 2000.
9
Income Taxes
The provision for income taxes consisted of:
Year Ended June 30 1998 1999 2000
- -----------------------------------------------------------------------
Current taxes:
U.S. and state $2,518 $4,027 $4,744
International 526 281 535
- -----------------------------------------------------------------------
Current taxes 3,044 4,308 5,279
Deferred taxes (417) (202) (425)
- -----------------------------------------------------------------------
Provision for income taxes $2,627 $4,106 $4,854
=======================================================================
U.S. and international components of income before income taxes were:
Year Ended June 30 1998 1999 2000
- ------------------------------------------------------------------
U.S. $5,072 $10,649 $11,860
International 2,045 1,242 2,415
- ------------------------------------------------------------------
Income before income taxes $7,117 $11,891 $14,275
==================================================================
The effective income tax rate increased to 36.9% in 1998 due to the
nondeductible write-off of WebTV in-process technologies. In 1999, the
effective tax rate was 35.0%, excluding the impact of the gain on the sale of
Softimage, Inc. In 2000, the effective tax rate was 34.0%, and included the
effect of a 2.5% reduction from the U.S. statutory rate for tax credits and a
1.5% increase for other items. The components of the differences between the
U.S. statutory tax rate and the Company's effective tax rate in 1998 and 1999
were not significant.
Deferred income taxes as of June 30 were:
- ------------------------------------------------------------------
1999 2000
- ------------------------------------------------------------------
Deferred income tax assets:
Revenue items $ 1,145 $ 1,320
Expense items 648 2,122
- ------------------------------------------------------------------
Deferred income tax assets 1,793 3,442
- ------------------------------------------------------------------
Deferred income tax liabilities:
Unrealized gain on investments (1,046) (874)
International earnings (647) (1,766)
Other (16) (121)
- ------------------------------------------------------------------
Deferred income tax liabilities $(1,709) $(2,761)
==================================================================
The Internal Revenue Service (IRS) has assessed taxes for 1990 and 1991, which
the Company is contesting in U.S. Tax Court. Income taxes, except for taxes
related to the 1990 and 1991 assessments, have been settled with the IRS for all
years through 1994. The IRS is examining the Company's U.S. income tax returns
for 1995 and 1996. Management believes any related adjustments that might be
required will not be material to the financial statements. Income taxes paid
were $1.1 billion in 1998, $874 million in 1999, and $800 million in 2000.
Convertible Preferred Stock
During 1996, Microsoft issued 12.5 million shares of 2.75% convertible
exchangeable principal-protected preferred stock. Net proceeds of $980 million
were used to repurchase common shares. The Company's convertible preferred
stock matured on December 15, 1999. Each preferred share was converted into
1.1273 common shares.
10
Common Stock
Shares of common stock outstanding were as follows:
Year Ended June 30 1998 1999 2000
- -------------------------------------------------------------------
Balance, beginning of year 4,816 4,940 5,109
Issued 202 213 229
Repurchased (78) (44) (55)
- -------------------------------------------------------------------
Balanced, end of year 4,940 5,109 5,283
===================================================================
Repurchase Program
In January 2000, the Company terminated its stock buyback program. Prior to
this termination, the Company periodically repurchased its common shares in the
open market to provide shares for issuance to employees under stock option and
stock purchase plans. During 1998, the Company executed two forward settlement
structured repurchase agreements with an independent third party totaling 42
million shares of stock and paid cash for a portion of the purchase price. In
1999, the Company settled the agreements by returning 28 million shares of
stock, based upon the stock price on the date of settlement. The timing and
method of settlement were at the discretion of the Company. The differential
between the cash paid and the price of Microsoft common stock on the date of the
agreement was originally reflected in common stock and paid-in capital.
Put Warrants
Prior to the termination of the stock buyback program, Microsoft enhanced the
program by selling put warrants to independent third parties. These put
warrants entitle the holders to sell shares of Microsoft common stock to the
Company on certain dates at specified prices. On June 30, 2000, warrants to put
157 million shares were outstanding with strike prices ranging from $70 to $78
per share. The put warrants expire between September 2000 and December 2002.
The outstanding put warrants permit a net-share settlement at the Company's
option and do not result in a put warrant liability on the balance sheet.
Other Comprehensive Income
The changes in the components of other comprehensive income are as follows:
Year Ended June 30 1998 1999 2000
- -----------------------------------------------------------------------------------------------------------------------------
Net unrealized investment gains/(losses):
Unrealized holding gains, net of tax effect of $355 in 1998,
$772 in 1999, and $248 in 2000 $ 660 $1,432 $ 531
Reclassification adjustment for gains included in
net income, net of tax effect of $(18) in 1998,
$(205) in 1999, and $(420) in 2000 (33) (380) (814)
- -----------------------------------------------------------------------------------------------------------------------------
Net unrealized investment gains/(losses) 627 1,052 (283)
Translation adjustments and other (124) 69 23
- -----------------------------------------------------------------------------------------------------------------------------
Other comprehensive income/(loss) $ 503 $1,121 $(260)
=============================================================================================================================
Employee Stock and Savings Plans
Employee Stock Purchase Plan
The Company has an employee stock purchase plan for all eligible employees.
Under the plan, shares of the Company's common stock may be purchased at six-
month intervals at 85% of the lower of the fair market value on the first or the
last day of each six-month period. Employees may purchase shares having a value
not exceeding 10% of their gross compensation during an offering period. During
1998, 1999, and 2000, employees purchased 4.4 million, 2.7 million, and 2.5
million shares at average prices of $27.21, $52.59, and $72.38 per share. At
June 30, 2000, 68.4 million shares were reserved for future issuance.
Savings Plan
The Company has a savings plan, which qualifies under Section 401(k) of the
Internal Revenue Code. Participating employees may contribute up to 15% of
their pretax salary, but not more than statutory limits. The Company
contributes fifty cents for each dollar a participant contributes, with a
maximum contribution of 3% of a
11
participant's earnings. Matching contributions were $39 million, $49 million,
and $65 million in 1998, 1999, and 2000.
Stock Option Plans
The Company has stock option plans for directors, officers, and employees, which
provide for nonqualified and incentive stock options. Options granted prior to
1995 generally vest over four and one-half years and expire 10 years from the
date of grant. Options granted during and after 1995 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 after 10 years. At June 30, 2000, options for 341 million
shares were vested and 734 million shares were available for future grants under
the plans.
Stock options outstanding were as follows:
Price per Share
-------------------------------
Weighted
Shares Range Average
- -------------------------------------------------------------------------
Balance, June 30, 1997 956 $ 0.56 - $ 29.80 $ 7.86
Granted 138 16.56 - 43.63 31.28
Exercised (176) 0.56 - 31.24 4.64
Canceled (25) 4.25 - 41.94 14.69
----
Balance, June 30, 1998 893 0.56 - 43.63 11.94
Granted 78 45.59 - 83.28 54.62
Exercised (175) 0.56 - 53.63 6.29
Canceled (30) 4.25 - 74.28 21.06
----
Balance, June 30, 1999 766 0.56 - 83.28 23.87
Granted 304 65.56 - 119.13 79.87
Exercised (198) 0.56 - 82.94 9.54
Canceled (40) 4.63 - 116.56 36.50
----
Balance, June 30, 2000 832 0.56 - 119.13 41.23
=========================================================================
For various price ranges, weighted average characteristics of outstanding stock
options at June 30, 2000 were as follows:
Outstanding Options Exercisable Options
----------------------------------------------------------------------------
Range of Remaining Weighted Average Weighted Average
Exercise Prices Shares Life (Years) Price Shares Price
- -------------------------------------------------------------------------------------------------
$0.56-$5.97 133 2.1 $ 4.57 127 $ 4.53
5.98-13.62 104 3.0 10.89 84 10.83
13.63-29.80 135 3.7 14.99 77 14.83
29.81-43.62 96 4.5 32.08 39 31.98
43.63-83.28 198 7.3 63.19 14 54.64
83.29-119.13 166 8.6 89.91 -- --
=================================================================================================
12
The Company follows Accounting Principles Board Opinion 25, Accounting for Stock
Issued to Employees, to account for stock option and employee stock purchase
plans. An alternative method of accounting for stock options is SFAS 123,
Accounting for Stock-Based Compensation. Under SFAS 123, employee stock options
are valued at grant date using the Black-Scholes valuation model, and this
compensation cost is recognized ratably over the vesting period. Had
compensation cost for the Company's stock option and employee stock purchase
plans been determined as prescribed by SFAS 123, pro forma income statements for
1998, 1999, and 2000 would have been as follows:
Year Ended June 30 1998 1999 2000
- ----------------------------------------------------------------------------------------------------------------------------------
Reported Pro Forma Reported Pro Forma Reported Pro Forma
------------------------------------------------------------------------------------
Revenue $15,262 $15,262 $19,747 $19,747 $22,956 $22,956
Operating expenses:
Cost of revenue 2,460 2,603 2,814 3,013 3,002 3,277
Research and development 2,601 2,963 2,970 3,479 3,775 4,817
Acquired in-process technology 296 296 -- -- -- --
Sales and marketing 2,828 2,977 3,231 3,438 4,141 4,483
General and administrative 433 508 689 815 1,009 1,243
Other expenses 230 230 115 115 92 92
- ----------------------------------------------------------------------------------------------------------------------------------
Total operating expenses 8,848 9,577 9,819 10,860 12,019 13,912
- ----------------------------------------------------------------------------------------------------------------------------------
Operating income 6,414 5,685 9,928 8,887 10,937 9,044
Investment income 703 703 1,803 1,803 3,182 3,182
Gain on sales -- -- 160 160 156 156
- ----------------------------------------------------------------------------------------------------------------------------------
Income before income taxes 7,117 6,388 11,891 10,850 14,275 12,382
Provision for income taxes 2,627 2,369 4,106 3,741 4,854 4,210
- ----------------------------------------------------------------------------------------------------------------------------------
Net income $ 4,490 $ 4,019 $ 7,785 $ 7,109 $ 9,421 $ 8,172
==================================================================================================================================
Diluted earnings per share $ 0.84 $ 0.75 $ 1.42 $ 1.30 $ 1.70 $ 1.48
==================================================================================================================================
The weighted average Black-Scholes value of options granted under the stock
option plans during 1998, 1999, and 2000 was $11.81, $20.90, and $36.67. Value
was estimated using a weighted average expected life of 5.3 years in 1998, 5.0
years in 1999, and 6.2 years in 2000, no dividends, volatility of .32 in 1998
and 1999 and .33 in 2000, and risk-free interest rates of 5.7%, 4.9%, and 6.2%
in 1998, 1999, and 2000.
13
Earnings Per Share
Basic earnings per share is computed on the basis of the weighted average number
of common shares outstanding. Diluted earnings per share is computed on the
basis of the weighted average number of common shares outstanding plus the
effect of outstanding preferred shares using the "if-converted" method, assumed
net-share settlement of common stock structured repurchases, and outstanding
stock options using the "treasury stock" method.
The components of basic and diluted earnings per share were as follows:
- ------------------------------------------------------------------------------------------
Year Ended June 30 1998 1999 2000
- ------------------------------------------------------------------------------------------
Net income $4,490 $7,785 $9,421
Preferred stock dividends 28 28 13
- ------------------------------------------------------------------------------------------
Net income available for common shareholders $4,462 $7,757 $9,408
==========================================================================================
Weighted average outstanding shares of common stock 4,864 5,028 5,189
Dilutive effect of:
Common stock under structured repurchases 6 13 --
Put warrants -- -- 2
Preferred stock 34 16 7
Employee stock options 458 425 338
- ------------------------------------------------------------------------------------------
Common stock and common stock equivalents 5,362 5,482 5,536
==========================================================================================
Earnings per share:
Basic $ 0.92 $ 1.54 $ 1.81
==========================================================================================
Diluted $ 0.84 $ 1.42 $ 1.70
==========================================================================================
Operational Transactions
In August 1997, Microsoft acquired WebTV Networks, Inc., an online service that
enables consumers to experience the Internet through their televisions via set-
top terminals based on proprietary technologies. A director of the Company
owned 10% of WebTV. Microsoft paid $425 million in stock and cash for WebTV.
The Company recorded an in-process technologies write-off of $296 million in the
first quarter of fiscal 1998.
In August 1998, the Company sold a wholly-owned subsidiary, Softimage, Inc. to
Avid Technology, Inc. and recorded a pretax gain of $160 million. As part of a
transitional service agreement, Microsoft agreed to make certain development
tools and management systems available to Avid for use in the Softimage
business.
In November 1998, Microsoft acquired LinkExchange, Inc., a leading provider of
online marketing services to Web site owners and small and medium-sized
businesses. Microsoft paid $265 million in stock.
In September 1999, the Company sold the entertainment city guide portion of MSN
Sidewalk to Ticketmaster Online-CitySearch, Inc. (TMCS) for a combination of
TMCS stock and warrants with a value of $223 million. The transaction also
included a distribution agreement. Microsoft recognized a gain of $156 million
on the sale and will recognize revenue amounts related to the distribution
arrangement over the term of the agreement.
In November 1999, Expedia, Inc. completed an initial public offering of its
common stock. Expedia, which is majority-owned by Microsoft, is a leading
provider of branded online travel services for leisure and small business
travelers. Expedia's financial results and financial condition are consolidated
with the operations of Microsoft.
In January 2000, the Company merged with Visio Corporation in a transaction that
was accounted for as a pooling of interests. Microsoft issued 14 million shares
in the exchange for the outstanding stock of Visio. Visio's assets and
liabilities, which were nominal, are included with those of Microsoft as of the
merger. Operating results for Visio from periods prior to the merger were not
material to the combined results of the two companies. Accordingly, the
financial statements for such periods have not been restated.
During fiscal 1999 and 2000, Microsoft also acquired several other entities
primarily providing online technologies and services. The Company did not
record significant in-process technology write-offs in connection with these
transactions.
14
Commitments
The Company has operating leases for most U.S. and international sales and
support offices and certain equipment. Rental expense for operating leases was
$95 million, $135 million, and $201 million in 1998, 1999, and 2000. Future
minimum rental commitments under noncancelable leases, in millions of dollars,
are: 2001, $178; 2002, $172; 2003, $160; 2004, $151; 2005, $139; and thereafter,
$437.
Microsoft has committed $299 million for constructing new buildings and $200
million for the manufacturing of products. During 1996, Microsoft and National
Broadcasting Company (NBC) established two MSNBC joint ventures: a 24-hour cable
news and information channel and an interactive online news service. Microsoft
agreed to pay $220 million over a five-year period for its interest in the cable
venture, to pay one-half of operational funding of both joint ventures for a
multiyear period, and to guarantee a portion of MSNBC debt.
Contingencies
On October 7, 1997, Sun Microsystems, Inc. ("Sun") brought suit against
Microsoft in the U.S. District Court for the Northern District of California.
Sun's complaint alleges several claims against Microsoft, all related to the
parties' relationship under a March 11, 1996 Technology License and Distribution
Agreement (Agreement) concerning certain Java programming language technology.
On March 24, 1998, the Court entered an order enjoining Microsoft from using the
Java Compatibility logo on Internet Explorer 4.0 and the Microsoft Software
Developers Kit (SDK) for Java 2.0. Microsoft has taken steps to fully comply
with the order.
On November 17, 1998, the Court entered an order granting Sun's request for a
preliminary injunction, holding that Sun had established a likelihood of success
on its copyright infringement claims, because Microsoft's use of Sun's
technology in its products was beyond the scope of the parties' license
agreement. The Court ordered Microsoft to make certain changes in its products
that include Sun's Java technology and to make certain changes in its Java
software development tools. The Court also enjoined Microsoft from entering
into any licensing agreements that were conditioned on exclusive use of
Microsoft's Java Virtual Machine. Microsoft appealed that ruling to the 9th
Circuit Court of Appeals on December 16, 1998.
On August 23, 1999 the 9th Circuit Court of Appeals vacated the November 1998
preliminary injunction and remanded the case to the District Court for further
proceedings. Sun immediately filed two motions to reinstate and expand the
scope of the earlier injunction on the basis of copyright infringement and
unfair competition. On January 25, 2000, the Court issued rulings on the two
motions, denying Sun's motion to reinstate the preliminary injunction on the
basis of copyright infringement and granting, in part, Sun's motion to reinstate
the preliminary injunction based on unfair competition. Microsoft is in
compliance with the terms of the partially reinstated preliminary injunction and
will not need to undertake any further action to comply with the terms of the
injunction. No other hearing or trial dates have been set.
The parties have filed multiple summary judgment motions on the interpretation
of the Agreement and on Sun's copyright and trademark infringement claims. On
February 25, 2000, the Court entered an order denying both parties' motions for
summary judgment as to whether the Agreement authorizes Microsoft to distribute
independently developed Java Technology. On April 5, 2000, the Trial Court
entered an order denying Sun's motion for summary judgment regarding the
interpretation of Section 2.7(a), which sets forth certain requirements that Sun
must meet when they deliver Java Technology to Microsoft. On May 9, 2000, the
Court entered an order granting Microsoft's motion to dismiss Sun's copyright
infringement claim and on May 25, 2000, the Court issued a tentative order
granting Microsoft's motion to dismiss Sun's claim that it is entitled to
liquidated damages based on the alleged improper posting of its source code by
Microsoft. The Court has indicated its intention to set a hearing on the
remaining motions in September 2000.
On May 18, 1998, the Antitrust Division of the U.S. Department of Justice (DOJ)
and a group of state Attorneys General filed two antitrust cases against
Microsoft in the U.S. District Court for the District of Columbia. The DOJ
complaint alleges violations of Sections 1 and 2 of the Sherman Act. The DOJ
complaint seeks declaratory relief as to the violations it asserts and
preliminary and permanent injunctive relief regarding: the inclusion of Internet
browsing software (or other software products) as part of Windows; the terms of
agreements regarding non-
15
Microsoft Internet browsing software (or other software products); taking or
threatening "action adverse" in consequence of a person's failure to license or
distribute Microsoft Internet browsing software (or other software product) or
distributing competing products or cooperating with the government; and
restrictions on the screens, boot-up sequence, or functions of Microsoft's
operating system products. The state Attorneys General allege largely the same
claims and various pendent state claims. The states seek declaratory relief and
preliminary and permanent injunctive relief similar to that sought by the DOJ,
together with statutory penalties under the state law claims. The foregoing
description is qualified in its entirety by reference to the full text of the
complaints and other papers on file in those actions, case numbers 98-1232 and
98-1233.
On May 22, 1998, Judge Jackson consolidated the two actions. The judge granted
Microsoft's motion for summary judgment as to the states' monopoly leverage
claim and permitted the remaining claims to proceed to trial. Trial began on
October 19, 1998 and ended with closing arguments on September 21, 1999. On
November 5, 1999, Judge Jackson issued his Findings of Fact. On April 3, 2000
the Court entered its Conclusions of Law, determining that Microsoft "tied"
Internet Explorer and Windows 95/98 in violation of Section 1 of the Sherman
Act, that Microsoft violated Section 2 of the Sherman Act by taking actions to
maintain its monopoly in the desktop-PC operating system market, and that
Microsoft attempted to monopolize the Internet browser market in violation of
Section 2 of the Sherman Act. The Court also held that Microsoft did not
violate Section 1 of the Sherman Act by entering into a number of contracts
challenged by the government. The Court established a schedule for
consideration of the remedy to be imposed in a final judgment. On April 28,
2000, the plaintiffs submitted a joint proposed remedy that included a proposed
break-up of Microsoft into two companies, an operating systems company, and a
company that would own all of Microsoft's other products and businesses.
Microsoft submitted its proposed remedy and its proposal for further remedy
proceedings on May 10, 2000. On June 7, 2000, Judge Jackson entered the
government's proposed order nearly verbatim as his final judgment in the case.
That judgment orders a divestiture that will create two separate companies, an
"Operating Systems Business" and an "Applications Business," to be implemented
one year following a final decision on appeal. It also provides for a broad
range of "conduct" remedies that would have gone into effect in 90 days, absent
a stay. On June 13, 2000, Microsoft appealed to the United States Court of
Appeals. The Court of Appeals immediately entered an order notifying the parties
that the Court would hear all matters related to this appeal en banc. The
government then asked Judge Jackson to enter an order certifying the case for
direct appeal to the Supreme Court. On June 20, 2000, Judge Jackson certified
the case for direct appeal to the Supreme Court and simultaneously granted
Microsoft's request to stay the entire remedy pending final appeal. The
certification divests the Court of Appeals of jurisdiction over the case until
the Supreme Court decides whether or not to accept jurisdiction of the case,
which is entirely discretionary. The parties have agreed to a briefing schedule
on this issue, according to which Microsoft filed its Jurisdictional Statement
on July 26, 2000, the government responded on August 15, 2000, and Microsoft
replied on August 22, 2000. If the Supreme Court declines to accept
jurisdiction, the appeal will return to the Court of Appeals. If the Supreme
Court accepts jurisdiction, a schedule will be established for briefing and oral
argument on the merits of our appeal.
In other ongoing investigations, the DOJ and several state Attorneys General
have requested information from Microsoft concerning various issues. In
addition, the European Commission has instituted proceedings in which it alleges
that Microsoft has failed to disclose information that Sun claims it needs to
interoperate fully with Windows 2000 clients and has engaged in discriminatory
licensing of such technology. The remedies sought, though not fully defined,
include mandatory disclosure of Microsoft intellectual property concerning
Windows operating systems and imposition of fines. Microsoft denies the
Commission's allegations and intends to contest the proceedings vigorously.
A large number of antitrust class action lawsuits have been initiated against
Microsoft. These cases allege that Microsoft has competed unfairly and
unlawfully monopolized alleged markets for operating systems and certain
software applications and seek to recover alleged overcharges that the
complaints contend Microsoft charged for these products. Microsoft believes the
claims are without merit and is vigorously defending the cases.
The Securities and Exchange Commission is conducting a non-public investigation
into the Company's accounting reserve practices. Microsoft is also subject to
various legal proceedings and claims that arise in the ordinary course of
business.
16
Management currently believes that resolving these matters will not have a
material adverse impact on the Company's financial position or its results of
operations.
Segment Information
Year Ended June 30
Productivity
Windows Applications Consumer and Reconciling
Platforms and Developer Other Amounts Consolidated
- -------------------------------------------------------------------------------------------------------------------------
1998
Revenue $6,236 $ 7,458 $ 1,765 $ (197) $15,262
Operating income 3,661 4,824 (1,050) (1,021) 6,414
=========================================================================================================================
1999
Revenue $8,570 $ 8,636 $ 1,854 $ 687 $19,747
Operating income 5,476 4,950 (1,241) 743 9,928
=========================================================================================================================
2000
Revenue $9,265 $10,089 $ 2,718 $ 884 $22,956
Operating income 5,813 4,935 (1,455) 1,644 10,937
=========================================================================================================================
The Company's organizational structure and fundamental approach to business
reflect the needs of its customers. As such, Microsoft has three major
segments: Windows Platforms; Productivity Applications and Developer; and
Consumer and Other. Windows Platforms includes the Windows Division, which is
primarily responsible for developing and marketing Windows NT Workstation,
Windows 2000 Professional, Windows 98, Windows 95, Windows NT Server, and
Windows 2000 Server. Productivity Applications and Developer includes the
Business Productivity Division, which is responsible for developing and
marketing desktop applications, server applications, and developer tools.
Consumer and Other products and services include primarily learning,
entertainment, and PC input device products; WebTV and PC online access; and
portal and vertical properties. Assets of the segment groups are not relevant
for management of the businesses nor for disclosure.
Segment information is presented in accordance with SFAS 131, Disclosures about
Segments of an Enterprise and Related Information. This standard is based on a
management approach, which requires segmentation based upon the Company's
internal organization and disclosure of revenue and operating income based upon
internal accounting methods. The Company's financial reporting systems present
various data for management to run the business, including internal profit and
loss statements (P&Ls) prepared on a basis not consistent with generally
accepted accounting principles. Reconciling items include certain elements of
unearned revenue, the treatment of certain channel inventory amounts and
estimates, and the classification of revenue from product support and
consulting. Additionally, the internal P&Ls use accelerated methods of
depreciation and amortization. In fiscal 2000, the Company's internal P&Ls
included the Black-Scholes value of employee stock option grants, amortized over
the remaining months of the fiscal year of the grant, as well as minor changes
to the segments' composition due to various internal reorganizations during the
year. Fiscal 1999 disclosures have been restated for consistent presentation.
It is not practicable to restate fiscal 1998 for these changes.
Revenue attributable to U.S. operations includes shipments to customers in the
United States, licensing to OEMs and certain multinational organizations, and
exports of finished goods, primarily to Asia, Latin America, and Canada.
Revenue from U.S operations totaled $10.1 billion, $13.7 billion, and $15.7
billion in 1998, 1999, and 2000. Revenue from outside the United States,
excluding licensing to OEMs and certain multinational organizations and U.S.
exports, totaled $5.2 billion, $6.0 billion, and $7.3 billion in 1998, 1999, and
2000.
Long-lived assets totaled $1.5 billion and $1.8 billion in the United States in
1999 and 2000 and $154 million and $126 million in other countries in 1999 and
2000.
17
Independent Auditors' Report
- --------------------------------------------------------------------------------
To the Board of Directors and Stockholders of Microsoft Corporation:
We have audited the accompanying consolidated balance sheets of Microsoft
Corporation and subsidiaries as of June 30, 1999 and 2000, and the related
consolidated statements of income, cash flows, and stockholders' equity for each
of the three years in the period ended June 30, 2000. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of Microsoft Corporation and
subsidiaries as of June 30, 1999 and 2000, and the results of their operations
and their cash flows for each of the three years in the period ended June 30,
2000 in conformity with accounting principles generally accepted in the United
States of America.
Deloitte & Touche LLP
Seattle, Washington
July 18, 2000
18