Edgar Filing: MICROSOFT CORP

Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the Quarterly Period Ended December 31, 2011

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

For the Transition Period From to

Commission File Number: 0-14278

MICROSOFT CORPORATION

(Exact name of registrant as specified in its charter)


Washington		91-1144442
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

One Microsoft Way, Redmond, Washington		98052-6399
(Address of principal executive offices)		(Zip Code)

(425) 882-8080

(Registrant’s telephone number, including area code)

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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

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


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

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

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


Class	Outstanding at January 17, 2012


Common Stock, $0.00000625 par value per share		8,390,771,388 shares

MICROSOFT CORPORATION

FORM 10-Q

For the Quarter Ended December 31, 2011

INDEX


				Page
PART I.	FINANCIAL INFORMATION

	Item 1.	Financial Statements

		a)	Income Statements for the Three and Six Months Ended December 31, 2011 and 2010		3

		b)	Balance Sheets as of December 31, 2011 and June 30, 2011		4

		c)	Cash Flows Statements for the Three and Six Months Ended December 31, 2011 and 2010		5

		d)	Stockholders’ Equity Statements for the Three and Six Months Ended December 31, 2011 and 2010		6

		e)	Notes to Financial Statements		7

		f)	Report of Independent Registered Public Accounting Firm		27

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations			28

	Item 3.	Quantitative and Qualitative Disclosures About Market Risk			44

	Item 4.	Controls and Procedures			45

PART II.	OTHER INFORMATION

	Item 1.	Legal Proceedings			45

	Item 1A.	Risk Factors			45

	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds			51

	Item 6.	Exhibits			52

SIGNATURE					53

PART I

Item 1

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

INCOME STATEMENTS


(In millions, except per share amounts) (Unaudited)	Three Months Ended December 31,				Six Months Ended December 31,


	2011		2010		2011		2010

Revenue	$	20,885	$	19,953	$	38,257	$	36,148
Operating expenses:
Cost of revenue		5,638		4,833		9,415		7,972
Research and development		2,371		2,185		4,700		4,381
Sales and marketing		3,762		3,825		6,662		6,631
General and administrative		1,120		945		2,283		1,883

Total operating expenses		12,891		11,788		23,060		20,867

Operating income		7,994		8,165		15,197		15,281
Other income		245		332		348		446

Income before income taxes		8,239		8,497		15,545		15,727
Provision for income taxes		1,615		1,863		3,183		3,683

Net income	$	6,624	$	6,634	$	12,362	$	12,044


Earnings per share:
Basic	$	0.79	$	0.78	$	1.47	$	1.41
Diluted	$	0.78	$	0.77	$	1.46	$	1.39

Weighted average shares outstanding:
Basic		8,402		8,497		8,397		8,555
Diluted		8,465		8,570		8,489		8,646

Cash dividends declared per common share	$	0.20	$	0.16	$	0.40	$	0.32

See accompanying notes.

PART I

Item 1

BALANCE SHEETS


(In millions) (Unaudited)


December 31, 2011				June 30, 2011	⁽¹⁾
Assets
Current assets:
Cash and cash equivalents	$	10,610	$	9,610
Short-term investments (including securities loaned of $831 and $1,181)		41,126		43,162

Total cash, cash equivalents, and short-term investments		51,736		52,772
Accounts receivable, net of allowance for doubtful accounts of $321 and $333		13,643		14,987
Inventories		1,351		1,372
Deferred income taxes		2,169		2,467
Other		3,614		3,320

Total current assets		72,513		74,918
Property and equipment, net of accumulated depreciation of $10,546 and $9,829		8,010		8,162
Equity and other investments		7,550		10,865
Goodwill		19,670		12,581
Intangible assets, net		2,581		744
Other long-term assets		1,919		1,434

Total assets	$	112,243	$	108,704

Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	$	3,884	$	4,197
Accrued compensation		2,677		3,575
Income taxes		921		580
Short-term unearned revenue		13,985		15,722
Securities lending payable		849		1,208
Other		3,057		3,492

Total current liabilities		25,373		28,774
Long-term debt		11,932		11,921
Long-term unearned revenue		1,349		1,398
Deferred income taxes		1,082		1,456
Other long-term liabilities		8,386		8,072

Total liabilities		48,122		51,621

Commitments and contingencies
Stockholders’ equity:
Common stock and paid-in capital—shares authorized 24,000; outstanding 8,382 and 8,376		63,902		63,415
Retained earnings (deficit), including accumulated other comprehensive income of $826 and $1,863		219		(6,332	)

Total stockholders’ equity		64,121		57,083

Total liabilities and stockholders’ equity	$	112,243	$	108,704

(1)	Derived from audited financial statements.

See accompanying notes.

PART I

Item 1

CASH FLOWS STATEMENTS


(In millions) (Unaudited)	Three Months Ended December 31,						Six Months Ended December 31,


	2011			2010			2011			2010

Operations
Net income	$	6,624		$	6,634		$	12,362		$	12,044
Adjustments to reconcile net income to net cash from operations:
Depreciation, amortization, and other		678			663			1,404			1,357
Stock-based compensation expense		575			553			1,133			1,081
Net recognized gains on investments and derivatives		(112	)		(226	)		(142	)		(255	)
Excess tax benefits from stock-based compensation		(4	)		(4	)		(74	)		(9	)
Deferred income taxes		14			(117	)		416			(265	)
Deferral of unearned revenue		7,544			6,834			13,683			12,715
Recognition of unearned revenue		(8,057	)		(7,301	)		(15,710	)		(14,163	)
Changes in operating assets and liabilities:
Accounts receivable		(3,652	)		(3,270	)		1,081			404
Inventories		891			380			(29	)		(88	)
Other current assets		605			(77	)		865			131
Other long-term assets		30			118			(45	)		180
Accounts payable		176			216			(266	)		(184	)
Other current liabilities		394			(500	)		(599	)		(1,411	)
Other long-term liabilities		156			283			276			843

Net cash from operations		5,862			4,186			14,355			12,380

Financing
Short-term debt repayments, maturities of 90 days or less, net		0			(1,000	)		0			(186	)
Proceeds from issuance of debt, maturities longer than 90 days		0			0			0			4,721
Repayments of debt, maturities longer than 90 days		0			0			0			(814	)
Common stock issued		208			660			544			837
Common stock repurchased		(1,042	)		(5,052	)		(2,976	)		(9,451	)
Common stock cash dividends paid		(1,683	)		(1,363	)		(3,024	)		(2,481	)
Excess tax benefits from stock-based compensation		4			4			74			9
Other		0			0			0			(25	)

Net cash used in financing		(2,513	)		(6,751	)		(5,382	)		(7,390	)

Investing
Additions to property and equipment		(498	)		(491	)		(934	)		(1,055	)
Acquisition of companies, net of cash acquired, and purchases of intangible and other assets		(8,627	)		(69	)		(9,502	)		(69	)
Purchases of investments		(10,047	)		(5,896	)		(21,346	)		(13,313	)
Maturities of investments		6,061			1,836			8,886			2,706
Sales of investments		7,835			2,603			15,371			4,030
Securities lending payable		(292	)		447			(358	)		1,174

Net cash used in investing		(5,568	)		(1,570	)		(7,883	)		(6,527	)

Effect of exchange rates on cash and cash equivalents		(52	)		(3	)		(90	)		55

Net change in cash and cash equivalents		(2,271	)		(4,138	)		1,000			(1,482	)
Cash and cash equivalents, beginning of period		12,881			8,161			9,610			5,505

Cash and cash equivalents, end of period	$	10,610		$	4,023		$	10,610		$	4,023

See accompanying notes.

PART I

Item 1

STOCKHOLDERS’ EQUITY STATEMENTS


(In millions) (Unaudited)	Three Months Ended December 31,						Six Months Ended December 31,


	2011			2010			2011			2010

Common stock and paid-in capital
Balance, beginning of period	$	63,492		$	61,935		$	63,415		$	62,856
Common stock issued		208			660			544			837
Common stock repurchased		(340	)		(1,405	)		(1,164	)		(2,980	)
Stock-based compensation expense		575			553			1,133			1,081
Stock-based compensation income tax deficiencies		(35	)		(97	)		(29	)		(148	)
Other, net		2			0			3			0

Balance, end of period		63,902			61,646			63,902			61,646

Retained earnings (deficit)
Balance, beginning of period		(4,101	)		(14,993	)		(6,332	)		(16,681	)
Net income		6,624			6,634			12,362			12,044
Other comprehensive income:
Net unrealized gains (losses) on derivatives		76			(80	)		236			(586	)
Net unrealized gains (losses) on investments		124			284			(1,025	)		1,016
Translation adjustments and other		(125	)		(26	)		(248	)		212

Comprehensive income		6,699			6,812			11,325			12,686
Common stock cash dividends		(1,677	)		(1,337	)		(3,360	)		(2,699	)
Common stock repurchased		(702	)		(3,647	)		(1,414	)		(6,471	)

Balance, end of period		219			(13,165	)		219			(13,165	)

Total stockholders’ equity	$	64,121		$	48,481		$	64,121		$	48,481

See accompanying notes.

PART I

Item 1

NOTES TO FINANCIAL STATEMENTS

(Unaudited)

NOTE 1 ACCOUNTING POLICIES

Accounting Principles

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”). Interim results are not necessarily indicative of results for a full year. The information included in this Form 10-Q should be read in conjunction with information included in the Microsoft Corporation 2011 Form 10-K filed on July 28, 2011 with the U.S. Securities and Exchange Commission.

Principles of Consolidation

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

Estimates and Assumptions

Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples include: estimates of loss contingencies, product warranties, product life cycles, product returns, and stock-based compensation forfeiture rates; assumptions such as the elements comprising a software arrangement, including the distinction between upgrades/enhancements and new products; when technological feasibility is achieved for our products; the potential outcome of future tax consequences of events that have been recognized in our financial statements or tax returns; estimating the fair value and/or potential 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.

Recently Adopted Accounting Guidance

On July 1, 2011, we adopted guidance issued by the Financial Accounting Standards Board (“FASB”) on disclosure requirements related to fair value measurements. The guidance requires the disclosure of roll-forward activities on purchases, sales, issuance, and settlements of the assets and liabilities measured using significant unobservable inputs (Level 3 fair value measurements). Adoption of this new guidance did not have a material impact on our financial statements.

Recent Accounting Guidance Not Yet Adopted

In December 2011, the FASB issued guidance enhancing disclosure requirements about the nature of an entity’s right to offset and related arrangements associated with its financial instruments and derivative instruments. The new guidance requires the disclosure of the gross amounts subject to rights of set-off, amounts offset in accordance with the accounting standards followed, and the related net exposure. The new guidance will be effective for us beginning July 1, 2013. Other than requiring additional disclosures, we do not anticipate material impacts on our financial statements upon adoption.

In September 2011, the FASB issued guidance on testing goodwill for impairment. The new guidance provides an entity the option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If an entity determines that this is the case, it is required to perform the currently prescribed two-step goodwill impairment test to identify potential goodwill impairment and measure the amount of goodwill impairment loss to be recognized for that reporting unit (if any). If an entity determines that the fair value of a reporting unit is greater than its carrying amount, the two-step goodwill impairment test is not required. The new guidance will be effective for us beginning July 1, 2012.

In June 2011, the FASB issued guidance on presentation of comprehensive income. The new guidance eliminates the current option to report other comprehensive income and its components in the statement of changes in equity. Instead,

PART I

Item 1

an entity will be required to present either a continuous statement of net income and other comprehensive income or in two separate but consecutive statements. The new guidance also required entities to present reclassification adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which other comprehensive income is presented. In December 2011, the FASB issued guidance which indefinitely defers the guidance related to the presentation of reclassification adjustments. The new guidance will be effective for us beginning July 1, 2012 and will have financial statement presentation changes only.

In May 2011, the FASB issued guidance to amend the accounting and disclosure requirements on fair value measurements. The new guidance limits the highest-and-best-use measure to nonfinancial assets, permits certain financial assets and liabilities with offsetting positions in market or counterparty credit risks to be measured at a net basis, and provides guidance on the applicability of premiums and discounts. Additionally, the new guidance expands the disclosures on Level 3 inputs by requiring quantitative disclosure of the unobservable inputs and assumptions, as well as description of the valuation processes and the sensitivity of the fair value to changes in unobservable inputs. The new guidance will be effective for us beginning January 1, 2012. Other than requiring additional disclosures, we do not anticipate material impacts on our financial statements upon adoption.

NOTE 2 EARNINGS PER SHARE

Basic earnings per share (“EPS”) is computed based on the weighted average number of shares of common stock outstanding during the period. Diluted EPS is computed based on the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options, stock awards, and shared performance stock awards. The components of basic and diluted EPS are as follows:


(In millions, except earnings per share)	Three Months Ended December 31,				Six Months Ended December 31,


	2011		2010		2011		2010

Net income available for common shareholders (A)	$	6,624	$	6,634	$	12,362	$	12,044

Weighted average outstanding shares of common stock (B)		8,402		8,497		8,397		8,555
Dilutive effect of stock-based awards		63		73		92		91

Common stock and common stock equivalents (C)		8,465		8,570		8,489		8,646

Earnings Per Share:
Basic (A/B)	$	0.79	$	0.78	$	1.47	$	1.41
Diluted (A/C)	$	0.78	$	0.77	$	1.46	$	1.39

We excluded the following shares underlying stock-based awards from the calculations of diluted EPS because their inclusion would have been anti-dilutive:

(In millions)

Three Months Ended

December 31,

Six Months Ended

December 31,

2011

2010

2011

2010

Shares excluded from calculations of diluted EPS

The decrease in anti-dilutive shares from the comparable period was due mainly to the decrease in employee stock options outstanding.

In June 2010, we issued $1.25 billion of zero-coupon debt securities that are convertible into shares of our common stock if certain conditions are met. As of December 31, 2011, none of these securities had met price or other conditions that would make them eligible for issuance and therefore were excluded from the calculation of either the basic or diluted EPS. See Note 11 – Debt for additional information.

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NOTE 3 OTHER INCOME

The components of other income were as follows:


(In millions)	Three Months Ended December 31,						Six Months Ended December 31,


		2011			2010			2011			2010

Dividends and interest income	$	182		$	205		$	393		$	415
Interest expense		(95	)		(72	)		(189	)		(117	)
Net recognized gains on investments		315			118			318			152
Net gains (losses) on derivatives		(203	)		108			(176	)		103
Net losses on foreign currency remeasurements		(4	)		(27	)		(44	)		(69	)
Other		50			0			46			(38	)

Total	$	245		$	332		$	348		$	446

Following are details of net recognized gains on investments during the periods reported:


(In millions)	Three Months Ended December 31,						Six Months Ended December 31,


		2011			2010			2011			2010

Other-than-temporary impairments of investments	$	(107	)	$	(18	)	$	(152	)	$	(27	)
Realized gains from sales of available-for-sale securities		643			214			843			315
Realized losses from sales of available-for-sale securities		(221	)		(78	)		(373	)		(136	)

Total	$	315		$	118		$	318		$	152

NOTE 4 INVESTMENTS

Investment Components

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


(In millions)	Cost Basis		Unrealized Gains		Unrealized Losses			Recorded Basis		Cash and Cash Equivalents		Short-term Investments		Equity and Other Investments


December 31, 2011

Cash	$	2,349	$	0	$	0		$	2,349	$	2,349	$	0	$	0
Mutual funds		816		0		0			816		816		0		0
Commercial paper		465		0		0			465		350		115		0
Certificates of deposit		1,003		0		0			1,003		688		315		0
U.S. government and agency securities		31,548		153		(1	)		31,700		510		31,190		0
Foreign government bonds		888		26		(32	)		882		0		882		0
Mortgage-backed securities		1,910		111		(3	)		2,018		0		2,018		0
Corporate notes and bonds		11,891		180		(29	)		12,042		5,897		6,145		0
Municipal securities		403		54		0			457		0		457		0
Common and preferred stock		6,044		1,274		(478	)		6,840		0		0		6,840
Other investments		714		0		0			714		0		4		710

Total	$	58,031	$	1,798	$	(543	)	$	59,286	$	10,610	$	41,126	$	7,550

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(In millions)	Cost Basis		Unrealized Gains		Unrealized Losses			Recorded Basis		Cash and Cash Equivalents		Short-term Investments		Equity and Other Investments


June 30, 2011

Cash	$	1,648	$	0	$	0		$	1,648	$	1,648	$	0	$	0
Mutual funds		1,752		0		0			1,752		1,752		0		0
Commercial paper		639		0		0			639		414		225		0
Certificates of deposit		598		0		0			598		372		226		0
U.S. government and agency securities		33,607		162		(7	)		33,762		2,049		31,713		0
Foreign government bonds		658		11		(2	)		667		0		667		0
Mortgage-backed securities		2,307		121		(4	)		2,424		0		2,424		0
Corporate notes and bonds		10,575		260		(11	)		10,824		3,375		7,449		0
Municipal securities		441		15		(2	)		454		0		454		0
Common and preferred stock		7,925		2,483		(193	)		10,215		0		0		10,215
Other investments		654		0		0			654		0		4		650

Total	$	60,804	$	3,052	$	(219	)	$	63,637	$	9,610	$	43,162	$	10,865

Unrealized Losses on Investments

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


	Less than 12 Months					12 Months or Greater							Total Unrealized Losses

(In millions)	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Total Fair Value


December 31, 2011

U.S. government and agency securities	$	1,140	$	(1	)	$	0	$	0		$	1,140	$	(1	)
Foreign government bonds		268		(32	)		0		0			268		(32	)
Mortgage-backed securities		0		0			54		(3	)		54		(3	)
Corporate notes and bonds		1,167		(28	)		32		(1	)		1,199		(29	)
Common and preferred stock		1,954		(440	)		109		(38	)		2,063		(478	)

Total	$	4,529	$	(501	)	$	195	$	(42	)	$	4,724	$	(543	)


	Less than 12 Months					12 Months or Greater							Total Unrealized Losses

(In millions)	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Total Fair Value


June 30, 2011

U.S. government and agency securities	$	484	$	(7	)	$	0	$	0		$	484	$	(7	)
Foreign government bonds		365		(2	)		0		0			365		(2	)
Mortgage-backed securities		63		(3	)		14		(1	)		77		(4	)
Corporate notes and bonds		750		(10	)		25		(1	)		775		(11	)
Municipal securities		79		(2	)		0		0			79		(2	)
Common and preferred stock		1,377		(146	)		206		(47	)		1,583		(193	)

Total	$	3,118	$	(170	)	$	245	$	(49	)	$	3,363	$	(219	)

Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic and international equities are due to market price movements. Management does not believe any remaining unrealized losses represent other-than-temporary impairments based on our evaluation of available evidence as of December 31, 2011.

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At December 31, 2011 and June 30, 2011, the recorded bases of common and preferred stock and other investments that are restricted for more than one year or are not publicly traded were $433 million and $334 million, respectively. These investments are carried at cost and are reviewed quarterly for indicators of other-than-temporary impairment.

Debt Investment Maturities


(In millions)	Cost Basis		Estimated Fair Value


December 31, 2011

Due in one year or less	$	24,231	$	24,275
Due after one year through five years		18,304		18,432
Due after five years through 10 years		3,126		3,247
Due after 10 years		2,447		2,613

Total	$	48,108	$	48,567

NOTE 5 DERIVATIVES

We use derivative instruments to: manage risks related to foreign currencies, equity prices, interest rates, and credit; to enhance investment returns; and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Our derivative programs include strategies that both qualify and do not qualify for hedge accounting treatment. All notional amounts presented below are measured in U.S. currency equivalents.

Foreign Currency

Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge positions. Option and forward contracts are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash flow hedging instruments. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. As of December 31, 2011 and June 30, 2011, the total notional amounts of these foreign exchange contracts sold were $9.4 billion and $10.6 billion, respectively.

Foreign currency risks related to certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are designated as fair value hedging instruments. As of December 31, 2011 and June 30, 2011, the total notional amounts of these foreign exchange contracts sold were $481 million and $572 million, respectively.

Certain options and forwards not designated as hedging instruments are also used to manage the variability in exchange rates on accounts receivable, cash, and intercompany positions, and to manage other foreign currency exposures. As of December 31, 2011, the total notional amounts of these foreign exchange contracts purchased and sold were $3.0 billion and $7.0 billion, respectively. As of June 30, 2011, the total notional amounts of these foreign exchange contracts purchased and sold were $4.3 billion and $7.1 billion, respectively.

Equity

Securities held in our equity and other investments portfolio are subject to market price risk. Market price risk is managed relative to broad-based global and domestic equity indices using certain convertible preferred investments, options, futures, and swap contracts not designated as hedging instruments. From time to time, to hedge our price risk, we may use and designate equity derivatives as hedging instruments, including puts, calls, swaps, and forwards. As of December 31, 2011, the total notional amounts of designated and non-designated equity contracts purchased and sold were $1.1 billion and $779 million, respectively. As of June 30, 2011, the total notional amounts of designated and non-designated equity contracts purchased and sold were $1.1 billion and $860 million, respectively.

PART I

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Interest Rate

Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of our fixed-income portfolio to achieve economic returns that correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts and over-the-counter swap and option contracts, none of which are designated as hedging instruments. As of December 31, 2011, the total notional amounts of fixed-interest rate contracts purchased and sold were $1.2 billion and $846 million, respectively. As of June 30, 2011, the total notional amounts of fixed-interest rate contracts purchased and sold were $2.3 billion and $697 million, respectively.

In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed securities. These meet the definition of a derivative instrument in cases where physical delivery of the assets is not taken at the earliest available delivery date. As of December 31, 2011 and June 30, 2011, the total notional derivative amount of mortgage contracts purchased were $1.1 billion and $868 million, respectively.

Credit

Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts, not designated as hedging instruments, to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. We use credit default swaps as they are a low-cost method of managing exposure to individual credit risks or groups of credit risks. As of December 31, 2011, the total notional amounts of credit contracts purchased and sold were $221 million and $297 million, respectively. As of June 30, 2011, the total notional amounts of credit contracts purchased and sold were $532 million and $281 million, respectively.

Commodity

We use broad-based commodity exposures to enhance portfolio returns and to facilitate portfolio diversification. We use swap, futures and option contracts, not designated as hedging instruments, to generate and manage exposures to broad-based commodity indices. We use derivatives on commodities as they can be low-cost alternatives to the purchase and storage of a variety of commodities, including, but not limited to, precious metals, energy, and grain. As of December 31, 2011, the total notional amounts of commodity contracts purchased and sold were $1.3 billion and $458 million, respectively. As of June 30, 2011, the total notional amounts of commodity contracts purchased and sold were $1.9 billion and $502 million, respectively.

Credit-Risk-Related Contingent Features

Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured debt to maintain an investment grade credit rating and require us to maintain a minimum liquidity of $1.0 billion. To the extent we fail to meet these requirements, we will be required to post collateral, similar to the standard convention related to over-the-counter derivatives. As of December 31, 2011, our long-term unsecured debt rating was AAA, and cash investments were in excess of $1.0 billion. As a result, no collateral was required to be posted.

Fair Values of Derivative Instruments

Derivative instruments are recognized as either assets or liabilities and are measured at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation.

For derivative instruments designated as fair value hedges, the gain (loss) is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged items attributed to the risk being hedged. For options designated as fair-value hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings.

For derivative instruments designated as cash-flow hedges, the effective portion of the derivative’s gain (loss) is initially reported as a component of other comprehensive income (“OCI”) and is subsequently recognized in earnings when the hedged exposure is recognized in earnings. For options designated as cash-flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. Gains (losses) on derivatives representing either hedge components excluded from the assessment of effectiveness or hedge ineffectiveness are recognized in earnings.

PART I

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For derivative instruments that are not designated as hedges, gains (losses) from changes in fair values are primarily recognized in other income (expense). Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities, which are recorded as a component of OCI until the securities are sold or other-than-temporarily impaired, at which time the amounts are moved from OCI into other income (expense).

The following tables present the gross fair values of derivative instruments designated as hedging instruments (“designated hedge derivatives”) and not designated as hedging instruments (“non-designated hedge derivatives”). The fair values exclude the impact of netting derivative assets and liabilities when a legally enforceable master netting agreement exists and fair value adjustments related to our own credit risk and counterparty credit risk:


(In millions)	Foreign Exchange Contracts			Equity Contracts			Interest Rate Contracts			Credit Contracts			Commodity Contracts			Total Derivatives


December 31, 2011

Assets
Non-designated hedge derivatives:
Short-term investments	$	36		$	136		$	14		$	27		$	6		$	219
Other current assets		127			0			0			0			0			127

Total	$	163		$	136		$	14		$	27		$	6		$	346
Designated hedge derivatives:
Short-term investments	$	9		$	0		$	0		$	0		$	0		$	9
Other current assets		330			0			0			0			0			330

Total	$	339		$	0		$	0		$	0		$	0		$	339

Total assets	$	502		$	136		$	14		$	27		$	6		$	685

Liabilities
Non-designated hedge derivatives:
Other current liabilities	$	(108	)	$	(11	)	$	(22	)	$	(20	)	$	(3	)	$	(164	)
Designated hedge derivatives:
Other current liabilities	$	(30	)	$	0		$	0		$	0		$	0		$	(30	)

Total liabilities	$	(138	)	$	(11	)	$	(22	)	$	(20	)	$	(3	)	$	(194	)

PART I

Item 1


(In millions)	Foreign Exchange Contracts			Equity Contracts			Interest Rate Contracts			Credit Contracts			Commodity Contracts			Total Derivatives


June 30, 2011

Assets
Non-designated hedge derivatives:
Short-term investments	$	14		$	179		$	0		$	17		$	4		$	214
Other current assets		73			0			0			0			0			73

Total	$	87		$	179		$	0		$	17		$	4		$	287
Designated hedge derivatives:
Short-term investments	$	6		$	0		$	0		$	0		$	0		$	6
Other current assets		123			0			0			0			0			123

Total	$	129		$	0		$	0		$	0		$	0		$	129

Total assets	$	216		$	179		$	0		$	17		$	4		$	416

Liabilities
Non-designated hedge derivatives:
Other current liabilities	$	(91	)	$	(12	)	$	(9	)	$	(19	)	$	(4	)	$	(135	)
Designated hedge derivatives:
Other current liabilities	$	(128	)	$	0		$	0		$	0		$	0		$	(128	)

Total liabilities	$	(219	)	$	(12	)	$	(9	)	$	(19	)	$	(4	)	$	(263	)

See also Note 4 – Investments and Note 6 – Fair Value Measurements.

Fair-Value Hedge Gains (Losses)

We recognized in other income the following gains (losses) on contracts designated as fair value hedges and their related hedged items:


(In millions)	Three Months Ended December 31,						Six Months Ended December 31,


	2011			2010			2011			2010

Foreign Exchange Contracts
Derivatives	$	4		$	2		$	48		$	(50	)
Hedged items		(5	)		(2	)		(48	)		48

Total	$	(1	)	$	0		$	0		$	(2	)

Cash Flow Hedge Gains (Losses)

We recognized the following gains (losses) on foreign exchange contracts designated as cash flow hedges (our only cash flow hedges during the periods presented):


(In millions)	Three Months Ended December 31,						Six Months Ended December 31,


	2011			2010			2011			2010

Effective Portion
Gain (loss) recognized in OCI, net of tax effect of $33 and $(24) for the three months ended December 31, 2011 and 2010, and $102 and $(267) for the six months ended December 31, 2011 and 2010	$	62		$	(45	)	$	190		$	(497	)
Gain (loss) reclassified from OCI into revenue		(21	)		55			(70	)		139
Amount Excluded from Effectiveness Assessment and Ineffective Portion
Loss recognized in other income		(127	)		(16	)		(65	)		(103	)

PART I

Item 1

We estimate that $84 million of net derivative gains included in OCI at December 31, 2011 will be reclassified into earnings within the following 12 months. No significant amounts of gains (losses) were reclassified from OCI into earnings as a result of forecasted transactions that failed to occur during the three and six months ended December 31, 2011.

Non-Designated Derivative Gains (Losses)

Gains (losses) from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense). These amounts are shown in the table below, with the exception of gains (losses) on derivatives presented in income statement line items other than other income (expense), which were immaterial for the periods presented. Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) below are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities.


(In millions)	Three Months Ended December 31,						Six Months Ended December 31,


	2011			2010			2011			2010

Foreign exchange contracts	$	(16	)	$	(25	)	$	(65	)	$	(85	)
Equity contracts		(79	)		(2	)		(68	)		31
Interest-rate contracts		15			24			58			12
Credit contracts		10			10			(7	)		28
Commodity contracts		2			93			(88	)		158

Total	$	(68	)	$	100		$	(170	)	$	144

NOTE 6 FAIR VALUE MEASUREMENTS

We account for certain assets and liabilities at fair value. The hierarchy below lists three levels of fair value based on the extent to which inputs used in measuring fair value are observable in the market. We categorize each of our fair value measurements in one of these three levels based on the lowest level input that is significant to the fair value measurement in its entirety. These levels are:

•

Level 1—inputs are based upon unadjusted quoted prices for identical instruments traded in active markets. Our Level 1 non-derivative investments primarily include U.S. treasuries, domestic and international equities, and actively traded mutual funds. Our Level 1 derivative assets and liabilities include those actively traded on exchanges.

•

Level 2—inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques (e.g. the Black-Scholes model) for which all significant inputs are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, foreign exchange rates, and forward and spot prices for currencies and commodities. Our Level 2 non-derivative investments consist primarily of corporate notes and bonds, mortgage-backed securities, agency securities, certificates of deposit, and commercial paper. Our Level 2 derivative assets and liabilities primarily include certain over-the-counter option and swap contracts.

•

Level 3—inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques, including option pricing models and discounted cash flow models. Our Level 3 non-derivative assets primarily comprise investments in certain corporate bonds. We value these corporate bonds using internally developed valuation models, inputs to which include interest rate curves, credit spreads, stock prices, and volatilities. Unobservable inputs used in these models are significant to the fair values of the investments. Our Level 3 derivative assets and liabilities primarily comprise derivatives for foreign equities. In certain cases, market-based observable inputs are not available and we use management judgment to develop assumptions to determine fair value for these derivatives.

We measure certain assets, including our cost and equity method investments, at fair value on a nonrecurring basis when they are deemed to be other-than-temporarily impaired. The fair values of these investments are determined based on valuation techniques using the best information available, and may include quoted market prices, market comparables, and discounted cash flow projections. An impairment charge is recorded when the cost of the investment exceeds its fair value and this condition is determined to be other-than-temporary.

PART I

Item 1

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The following tables present the fair value of our financial instruments that are measured at fair value on a recurring basis:



(In millions)		Level 1		Level 2		Level 3		Gross Fair Value		Netting	^(a)		Net Fair Value


December 31, 2011

Assets
Mutual funds	$	816	$	0	$	0	$	816	$	0		$	816
Commercial paper		0		465		0		465		0			465
Certificates of deposit		0		1,003		0		1,003		0			1,003
U.S. government and agency securities		23,240		8,467		0		31,707		0			31,707
Foreign government bonds		178		692		0		870		0			870
Mortgage-backed securities		0		2,010		0		2,010		0			2,010
Corporate notes and bonds		0		11,898		9		11,907		0			11,907
Municipal securities		0		457		0		457		0			457
Common and preferred stock		6,354		49		5		6,408		0			6,408
Derivatives		5		680		0		685		(185	)		500

Total	$	30,593	$	25,721	$	14	$	56,328	$	(185	)	$	56,143

Liabilities
Derivatives and other	$	4	$	190	$	0	$	194	$	(182	)	$	12



(In millions)		Level 1		Level 2		Level 3		Gross Fair Value		Netting	^(a)		Net Fair Value


June 30, 2011

Assets
Mutual funds	$	1,752	$	0	$	0	$	1,752	$	0		$	1,752
Commercial paper		0		639		0		639		0			639
Certificates of deposit		0		598		0		598		0			598
U.S. government and agency securities		23,591		10,175		0		33,766		0			33,766
Foreign government bonds		303		367		0		670		0			670
Mortgage-backed securities		0		2,428		0		2,428		0			2,428
Corporate notes and bonds		0		10,600		58		10,658		0			10,658
Municipal securities		0		454		0		454		0			454
Common and preferred stock		9,821		55		5		9,881		0			9,881
Derivatives		8		388		20		416		(204	)		212

Total	$	35,475	$	25,704	$	83	$	61,262	$	(204	)	$	61,058

Liabilities
Derivatives and other	$	109	$	257	$	0	$	366	$	(203	)	$	163

(a)	These amounts represent the impact of netting derivative assets and derivative liabilities when a legally enforceable master netting agreement exists and fair value adjustments related to our own credit risk and counterparty credit risk.

PART I

Item 1

The following table reconciles the total Net Fair Value of assets above to the balance sheet presentation of these same assets in Note 4 – Investments.


(In millions)


	December 31, 2011			June 30, 2011

Net fair value of assets measured at fair value on a recurring basis	$	56,143		$	61,058
Cash		2,349			1,648
Common and preferred stock measured at fair value on a nonrecurring basis		433			334
Other investments measured at fair value on a nonrecurring basis		710			650
Less derivative assets classified as other current assets		(350	)		(54	)
Other		1			1

Recorded basis of investment components	$	59,286		$	63,637

Changes in Financial Instruments Measured at Level 3 Fair Value on a Recurring Basis

The following tables present the changes during the periods presented in our Level 3 financial instruments that are measured at fair value on a recurring basis. The majority of these instruments consist of investment securities classified as available-for-sale with changes in fair value included in OCI.


(In millions)	Corporate Notes and Bonds			Common and Preferred Stock		Derivative Assets			Total


Three and Six Months Ended December 31, 2011

Balance as of June 30, 2011	$	58		$	5	$	20		$	83
Total realized and unrealized gains (losses):
Included in other income (expense)		0			0		(2	)		(2	)
Included in other comprehensive income		(21	)		0		0			(21	)

Balance as of September 30, 2011	$	37		$	5	$	18		$	60
Total realized and unrealized gains (losses):
Included in other income (expense)		0			0		(3	)		(3	)
Included in other comprehensive income		0			0		0			0
Conversions of Level 3 instruments to Level 1 instruments		(28	)		0		(15	)		(43	)

Balance as of December 31, 2011	$	9		$	5	$	0		$	14

Change in unrealized gains (losses) included in other income (expense) for the three months ended December 31, 2011 related to assets held as of December 31, 2011	$	0		$	0	$	0		$	0
Change in unrealized gains (losses) included in other income (expense) for the six months ended December 31, 2011 related to assets held as of December 31, 2011	$	0		$	0	$	0		$	0

PART I

Item 1


(In millions)	Corporate Notes and Bonds			Common and Preferred Stock		Derivative Assets			Total


Three and Six Months Ended December 31, 2010

Balance as of June 30, 2010	$	167		$	5	$	9		$	181
Total realized and unrealized gains (losses):
Included in other income (expense)		2			0		7			9
Included in other comprehensive income		(2	)		0		0			(2	)

Balance as of September 30, 2010	$	167		$	5	$	16		$	188
Total realized and unrealized gains (losses):
Included in other income (expense)		2			0		(1	)		1
Included in other comprehensive income		2			0		0			2

Balance as of December 31, 2010	$	171		$	5	$	15		$	191

Change in unrealized gains (losses) included in other income (expense) for the three months ended December 31, 2010 related to assets held as of December 31, 2010	$	2		$	0	$	(1	)	$	1
Change in unrealized gains (losses) included in other income (expense) for the six months ended December 31, 2010 related to assets held as of December 31, 2010	$	4		$	0	$	6		$	10

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

During the three and six months ended December 31, 2011 and 2010, we did not record any other-than-temporary impairments on those assets required to be measured at fair value on a nonrecurring basis.

NOTE 7 INVENTORIES

The components of inventories were as follows:


(In millions)


December 31, 2011			June 30, 2011

Raw materials	$	243	$	232
Work in process		81		56
Finished goods		1,027		1,084

Total	$	1,351	$	1,372

NOTE 8 BUSINESS COMBINATIONS

On October 13, 2011, we acquired all of the issued and outstanding shares of Skype Global S.á r.l. (“Skype”), a leading global provider of software applications and related Internet communications products based in Luxembourg, for $8.6 billion primarily in cash. Our purchase price allocations are preliminary and subject to revision as more detailed analyses are completed and additional information about fair value of assets and liabilities becomes available, including additional information relating to tax matters and finalization of our valuation of identified intangible assets. The major classes of assets and liabilities to which we preliminarily allocated the purchase price were: goodwill of $7.1 billion; identifiable intangible assets of $1.6 billion with a weighted average estimated useful life of 13 years, primarily marketing-related (trade name) and technology-based intangibles with estimated useful lives of 15 years and 5 years, respectively; and unearned revenue of $222 million. The goodwill recognized in connection with the acquisition is primarily attributable to our expectation of extending Skype’s brand and the reach of its networked platform, while enhancing Microsoft’s existing portfolio of real-time communications products and services. We preliminarily assigned the goodwill to the following segments: $4.2 billion to Entertainment and Devices Division, $2.8 billion to Microsoft Business Division, and $54 million to Online Services Division. Skype was consolidated into our results of operations starting October 13, 2011, the acquisition date.

PART I

Item 1

During the first six months of fiscal year 2012, we completed an additional three acquisitions for total consideration of $83 million, substantially all of which was paid in cash.

Pro forma results of operations have not been presented because the effects of the business combinations described in this Note, individually and in aggregate, were not material to our consolidated results of operations.

NOTE 9 GOODWILL

Changes in the carrying amount of goodwill were as follows:


(In millions)	Balance as of September 30, 2011		Acquisitions		Other			Balance as of December 31, 2011


Windows & Windows Live Division	$	89	$	0	$	0		$	89
Server and Tools		1,144		0		0			1,144
Online Services Division		6,373		54		0			6,427
Microsoft Business Division		4,119		2,843		(35	)		6,927
Entertainment and Devices Division		812		4,272		(1	)		5,083

Total	$	12,537	$	7,169	$	(36	)	$	19,670


(In millions)	Balance as of June 30, 2011		Acquisitions		Other			Balance as of December 31, 2011


Windows & Windows Live Division	$	89	$	0	$	0		$	89
Server and Tools		1,139		7		(2	)		1,144
Online Services Division		6,373		54		0			6,427
Microsoft Business Division		4,167		2,843		(83	)		6,927
Entertainment and Devices Division		813		4,272		(2	)		5,083

Total	$	12,581	$	7,176	$	(87	)	$	19,670

We do not expect any of the amounts recorded as goodwill to be deductible for tax purposes. The measurement period for purchase price allocations ends as soon as information on the facts and circumstances becomes available, but will not exceed 12 months. Adjustments in the purchase price allocation may require a recasting of the amounts allocated to goodwill retroactive to the period in which the acquisition occurred. Any change in the goodwill amounts resulting from foreign currency translations are presented as “other” in the above table. Also included within “other” are transfers between business segments due to reorganizations, as applicable.

NOTE 10 INTANGIBLE ASSETS

The components of intangible assets, all of which are finite-lived, were as follows:


(In millions)	Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount		Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount


						December 31, 2011		June 30, 2011

Technology-based^(a)	$	2,965	$	(2,012	)	$	953	$	2,356	$	(1,831	)	$	525
Marketing-related		1,361		(122	)		1,239		113		(98	)		15
Contract-based		1,190		(990	)		200		1,068		(966	)		102
Customer-related		440		(251	)		189		326		(224	)		102

Total	$	5,956	$	(3,375	)	$	2,581	$	3,863	$	(3,119	)	$	744

(a)	Technology-based intangible assets included $150 million and $179 million as of December 31, 2011 and June 30, 2011, respectively, of net carrying amount of software to be sold, leased, or otherwise marketed.

PART I

Item 1

Intangible assets amortization expense was $155 million and $264 million for the three and six months ended December 31, 2011, respectively, as compared with $126 million and $250 million for the three and six months ended December 31, 2010, respectively. Amortization of capitalized software was $28 million and $57 million for the three and six months ended December 31, 2011, respectively, and $30 million and $56 million for the three and six months ended December 31, 2010, respectively.

The following table outlines the estimated future amortization expense related to intangible assets held at December 31, 2011:


(In millions)


Year Ending June 30,

2012 (excluding the six months ended December 31, 2011)	$	284
2013		480
2014		314
2015		260
2016		216
Thereafter		1,027

Total	$	2,581

NOTE 11 DEBT

As of December 31, 2011, the total carrying value and estimated fair value of our long-term debt, including convertible debt, were $11.9 billion and $13.1 billion, respectively. This is compared to a carrying value and estimated fair value of $11.9 billion and $12.1 billion, respectively, as of June 30, 2011. The estimated fair value is based on quoted prices for our publicly-traded debt as of December 31, 2011 and June 30, 2011, as applicable.

The components of long-term debt, the associated interest rates, and the semi-annual interest record and payment dates were as follows as of December 31, 2011:

Due Date

Face Value

Stated
Interest

Rate

Effective
Interest

Rate

Interest

Record Date

Interest

Pay Date

Interest

Record Date

Interest

Pay Date

(In millions

)

Notes

September 27, 2013

1,000

0.875

1.000

March 15

March 27

September 15

September 27

June 1, 2014

2,000

2.950

3.049

May 15

June 1

November 15

December 1

September 25, 2015

1,750

1.625

1.795

March 15

March 25

September 15

September 25

February 8, 2016

750

2.500

2.642

February 1

February 8

August 1

August 8

June 1, 2019

1,000

4.200

4.379

May 15

June 1

November 15

December 1

October 1, 2020

1,000

3.000

3.137

March 15

April 1

September 15

October 1

February 8, 2021

500

4.000

4.082

February 1

February 8

August 1

August 8

June 1, 2039

750

5.200

5.240

May 15

June 1

November 15

December 1

October 1, 2040

1,000

4.500

4.567

March 15

April 1

September 15

October 1

February 8, 2041

1,000

5.300

5.361

February 1

February 8

August 1

August 8

Total

10,750

Convertible Debt

June 15, 2013

1,250

0.000

1.849

Total unamortized discount

(68

)

Total

11,932

PART I

Item 1

The components of long-term debt, the associated interest rates, and the semi-annual interest record and payment dates were as follows as of June 30, 2011:


Due Date	Face Value			Stated Interest Rate			Effective Interest Rate			Interest Record Date		Interest Pay Date		Interest Record Date		Interest Pay Date


		(In millions	)

Notes
September 27, 2013	$	1,000			0.875	%		1.000	%		March 15		March 27		September 15		September 27
June 1, 2014		2,000			2.950	%		3.049	%		May 15		June 1		November 15		December 1
September 25, 2015		1,750			1.625	%		1.795	%		March 15		March 25		September 15		September 25
February 8, 2016		750			2.500	%		2.642	%		February 1		February 8		August 1		August 8
June 1, 2019		1,000			4.200	%		4.379	%		May 15		June 1		November 15		December 1
October 1, 2020		1,000			3.000	%		3.137	%		March 15		April 1		September 15		October 1
February 8, 2021		500			4.000	%		4.082	%		February 1		February 8		August 1		August 8
June 1, 2039		750			5.200	%		5.240	%		May 15		June 1		November 15		December 1
October 1, 2040		1,000			4.500	%		4.567	%		March 15		April 1		September 15		October 1
February 8, 2041		1,000			5.300	%		5.361	%		February 1		February 8		August 1		August 8

Total		10,750

Convertible Debt
June 15, 2013		1,250			0.000	%		1.849	%
Total unamortized discount		(79	)

Total	$	11,921

Notes

The Notes are senior unsecured obligations and rank equally with our other unsecured and unsubordinated debt outstanding.

Convertible Debt

In June 2010, we issued $1.25 billion of zero coupon convertible unsecured debt due on June 15, 2013 in a private placement offering. Proceeds from the offering were $1.24 billion, net of fees and expenses, which were capitalized. Each $1,000 principal amount of notes is convertible into 29.94 shares of Microsoft common stock at a conversion price of $33.40 per share. As of December 31, 2011, the net carrying amount of our convertible debt was $1.2 billion and the unamortized discount was $28 million.

Prior to March 15, 2013, the notes will be convertible, only in certain circumstances, into cash and, if applicable, cash, shares of Microsoft’s common stock, or a combination thereof, at our election. On or after March 15, 2013, the notes will be convertible at any time. Upon conversion, we will pay cash up to the aggregate principal amount of the notes and pay or deliver cash, shares of our common stock or a combination of cash and shares of our common stock, at our election.

Because the convertible debt may be wholly or partially settled in cash, we are required to separately account for the liability and equity components of the notes in a manner that reflects our nonconvertible debt borrowing rate when interest costs are recognized in subsequent periods. The net proceeds of $1.24 billion were allocated between debt for $1.18 billion and stockholders’ equity for $58 million with the portion in stockholders’ equity representing the fair value of the option to convert the debt.

In connection with the issuance of the notes, we entered into capped call transactions with certain option counterparties who are initial purchasers of the notes or their affiliates. The capped call transactions are expected to reduce potential dilution of earnings per share upon conversion of the notes. Under the capped call transactions, we purchased from the option counterparties capped call options that in the aggregate relate to the total number of shares of our common stock underlying the notes, with a strike price equal to the conversion price of the notes and with a cap price equal to $37.16. The purchased capped calls were valued at $40 million and recorded to stockholders’ equity.

PART I

Item 1

NOTE 12 INCOME TAXES

Our effective tax rates were approximately 20% and 22% for the three months ended December 31, 2011 and 2010, respectively, and 20% and 23% for the six months ended December 31, 2011 and 2010, respectively. Our effective tax rate was lower than the U.S. federal statutory rate and prior year effective rates primarily due to a higher mix of earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico, which are subject to lower income tax rates.

Tax contingencies and other tax liabilities were $7.7 billion and $7.4 billion as of December 31, 2011 and June 30, 2011, respectively, and are included in other long-term liabilities. While we settled a portion of the I.R.S. audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, we remain under audit for these years. During the fourth quarter of fiscal year 2011, the I.R.S. completed its examination and issued a Revenue Agent’s Report (“RAR”) for the remaining unresolved items. We do not agree with the adjustments in the RAR, and we have filed a protest to initiate the administrative appeals process. The proposed adjustments are primarily related to transfer pricing and could have a significant impact on our financial statements if not resolved favorably. We do not believe it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months, as we do not believe the appeals process will be concluded within the next 12 months. We also continue to be subject to examination by the I.R.S. for tax years 2007 to 2011.

We are subject to income tax in many jurisdictions outside the U.S. Certain jurisdictions remain subject to examination for tax years 1996 to 2010, some of which are currently under audit by local tax authorities. The resolutions of these audits are not expected to be material to our financial statements.

NOTE 13 UNEARNED REVENUE

The components of unearned revenue were as follows:


(In millions)


December 31, 2011				June 30, 2011

Volume licensing programs	$	12,873	$	14,625
Other		2,461		2,495

Total	$	15,334	$	17,120

Unearned revenue by segment was as follows:


(In millions)


December 31, 2011				June 30, 2011

Windows & Windows Live Division	$	1,525	$	1,782
Server and Tools		5,612		6,315
Microsoft Business Division		7,085		8,187
Other segments		1,112		836

Total	$	15,334	$	17,120

Fiscal year 2011 amounts have been recast for the fiscal year 2012 movement of Forefront Protection for Office, an anti-malware solution, from Server and Tools to the Microsoft Business Division.

NOTE 14 COMMITMENTS AND GUARANTEES

Yahoo! Commercial Agreement

On December 4, 2009, we entered into a 10-year agreement with Yahoo! whereby Microsoft will provide the exclusive algorithmic and paid search platform for Yahoo! Web sites. Microsoft provided Yahoo! with revenue per search guarantees for a period of 18 months after implementation of the Microsoft search ads platform in each country, extended by an additional 12 months for the U.S. and Canada. These guarantees are calculated, paid, and adjusted periodically and are rate guarantees, not guarantees of search volume. We estimate the remaining cost of the revenue per search guarantees during the guarantee period could range up to $150 million. Microsoft also agreed to reimburse Yahoo! for certain costs of running algorithmic and paid search services prior to migration to Microsoft’s platform.

PART I

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Product Warranty

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:


(In millions)	Three Months Ended December 31,						Six Months Ended December 31,


		2011			2010			2011			2010

Balance, beginning of period	$	166		$	214		$	172		$	240
Accruals for warranties issued		19			19			31			32
Settlements of warranty claims		(18	)		(31	)		(36	)		(70	)

Balance, end of period	$	167		$	202		$	167		$	202

NOTE 15 CONTINGENCIES

Antitrust, Unfair Competition, and Overcharge Class Actions

A large number of antitrust and unfair competition class action lawsuits were filed against us in various state, federal, and Canadian courts on behalf of various classes of direct and indirect purchasers of our PC operating system and certain other software products. We obtained dismissals or reached settlements of all claims that have been made to date in the United States.

All settlements in the United States have received final court approval. Under the settlements, generally class members can obtain vouchers that entitle them to be reimbursed for purchases of a wide variety of platform-neutral computer hardware and software. The total value of vouchers that we may issue varies by state. We will make available to certain schools a percentage of those vouchers that are not issued or claimed (one-half to two-thirds depending on the state). The total value of vouchers we ultimately issue will depend on the number of class members who make claims and are issued vouchers. The maximum value of vouchers to be issued is approximately $2.7 billion. The actual costs of these settlements will be less than that maximum amount, depending on the number of class members and schools that are issued and redeem vouchers. We estimate the total cost to resolve all of the state overcharge class action cases will range between $1.9 billion and $2.0 billion. At December 31, 2011, we have recorded a liability related to these claims of approximately $524 million, which reflects our estimated exposure of $1.9 billion less payments made to date of approximately $1.4 billion mostly for vouchers, legal fees, and administrative expenses.

The three cases pending in British Columbia, Ontario, and Quebec, Canada have not been settled. In March 2010, the court in the British Columbia case certified it as a class action. On April 15, 2011, the British Columbia Court of Appeal reversed the class certification ruling and dismissed the case, holding that indirect purchasers do not have a claim. The plaintiffs have appealed to the Canadian Supreme Court. The other two actions have been stayed.

Other Antitrust Litigation and Claims

In November 2004, Novell, Inc. (“Novell”) filed a complaint in U.S. District Court for the District of Utah (later transferred to federal court 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. In March 2010, the trial court granted summary judgment in favor of Microsoft as to all remaining claims. The court of appeals reversed that ruling. Trial on the case took place in October 2011 and resulted in a mistrial because the jury was unable to reach a verdict. Microsoft expects to file a motion for judgment as a matter of law. The court has not set a new trial date.

Patent and Intellectual Property Claims

In 2003, we filed an action in U.S. District Court in California seeking a declaratory judgment that we do not infringe certain Alcatel-Lucent patents (although this action began before the merger of Alcatel and Lucent in 2006, for simplicity we refer to the post-merger entity of Alcatel-Lucent). In April 2008, a jury returned a verdict in Alcatel-Lucent’s favor in a

PART I

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trial on a consolidated group of one video and three user interface patents. The jury concluded that we had infringed two user interface patents and awarded $367 million in damages. In June 2008, the trial judge increased the amount of damages to $512 million to include $145 million of interest. We appealed that award. In December 2008, we entered into a settlement agreement resolving all other litigation pending between Microsoft and Alcatel-Lucent, leaving approximately $500 million remaining in dispute. In September 2009, the court of appeals affirmed the liability award but vacated the verdict and remanded the case to the trial court for a re-trial of the damages ruling, indicating the damages previously awarded were too high. Trial on the remanded damages claim was held in July 2011 and the jury awarded Alcatel-Lucent $70 million. We filed a motion for judgment as a matter of law, which the court granted in part, and reduced the judgment to $26 million, not including post-trial interest, which would have increased the judgment to approximately $41 million. Alcatel-Lucent appealed the court’s decision, and Microsoft cross-appealed. The parties have now entered into a confidential settlement agreement to resolve the matter.

In October 2003, Uniloc USA Inc. (“Uniloc”), a subsidiary of a Singapore-based company, filed a patent infringement suit in U.S. District Court in Rhode Island, claiming that product activation technology supporting Windows XP and certain other Microsoft programs violated a Uniloc patent. After we obtained a favorable summary judgment that we did not infringe any of the claims of this patent, the court of appeals vacated the trial court decision and remanded the case for trial. In April 2009, the jury returned a $388 million verdict against us, including a finding of willful infringement. In September 2009, the district court judge overturned the jury verdict, ruling that the evidence did not support the jury’s findings either that Microsoft infringed the patent or was willful. Uniloc appealed, and in January 2011 the court of appeals reversed the district court’s finding of non-infringement (thus reinstating the jury verdict of infringement) but affirmed the district court’s ruling that Microsoft was not willful and affirmed the district court’s grant of a new trial on damages. Uniloc’s petition for rehearing of the court of appeals’ decision as to damages was denied. A new trial on damages has been set for February 2012.

In October 2010, we filed suit against Motorola with the International Trade Commission (“ITC”) and in U.S. District Court in Washington for infringement of nine Microsoft patents by Motorola’s Android-based devices. Since then, Microsoft and Motorola have filed additional actions against each other in the ITC and federal courts in Washington, Wisconsin, Florida, California and Germany. Microsoft asserts Motorola’s Android-based devices violate 28 of its patents, and Motorola asserts various Microsoft products (including Windows, Windows Phone 7, Windows Mobile 6.5, Xbox, Bing Maps, Hotmail, Messenger, and Exchange Server) violate 24 Motorola patents. Microsoft also claims Motorola has breached its contractual commitments to the Institute of Electrical and Electronics Engineers and International Telecommunications Union to license identified patents related to wireless and video coding technologies under reasonable and non-discriminatory (“RAND”) terms and conditions. In the case originally filed in California, Motorola asserts that Microsoft breached contractual commitments to the SD Card Association to license two patents under RAND terms and conditions, and asserts federal antitrust and state unfair business practice claims. Trial in our ITC case took place in August 2011. In December 2011, the administrative law judge issued an initial determination that Motorola infringed one Microsoft patent, and recommended that the ITC issue a limited exclusion order against Motorola. The ITC’s ruling is expected in April 2012. Trial in Motorola’s ITC case is set for January 2012. All of the cases pending in Wisconsin, California and Florida, with the exception of one currently stayed case in Wisconsin, have been transferred to the Western District of Washington. The lawsuits filed in Germany by Motorola and Microsoft all allege patent infringement. A hearing in one of our German actions against Motorola took place in December 2011. Additional hearings are scheduled on Microsoft’s claims against Motorola in Germany in February, March, April, and June 2012. Motorola’s German actions against Microsoft are scheduled for trial in January and March 2012.

In addition to these cases, there are approximately 60 other patent infringement cases pending against Microsoft.

Other

We also are 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 statements, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future.

As of December 31, 2011, we had accrued aggregate liabilities of $411 million in other current liabilities and $295 million in other long-term liabilities for all of the contingent matters described in this note. While we intend to vigorously defend these matters, adverse outcomes that we estimate could reach approximately $560 million in aggregate beyond recorded amounts are reasonably possible. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact on our financial statements for the period in which the effects become reasonably estimable.

PART I

Item 1

NOTE 16 STOCKHOLDERS’ EQUITY

Share Repurchases

We repurchased the following shares of common stock during the periods presented:


(In millions)	Three Months Ended December 31,				Six Months Ended December 31,

	2011		2010		2011		2010

Shares of common stock repurchased		39		188		78		351
Value of common stock repurchased	$	1,000	$	5,000	$	2,000	$	9,000

We repurchased all shares with cash resources. As of December 31, 2011, approximately $10.2 billion remained of our $40.0 billion repurchase program that we announced on September 22, 2008. The repurchase program expires September 30, 2013 but may be suspended or discontinued at any time without notice.

Dividends

Our Board of Directors declared the following dividends during the periods presented:

Declaration Date

Dividend
Per Share

Record Date

Total Amount

Payment Date

(in millions)

Fiscal Year 2012

September 20, 2011

0.20

November 17, 2011

1,683

December 8, 2011

December 14, 2011

0.20

February 16, 2012

1,676

March 8, 2012

Fiscal Year 2011

September 21, 2010

0.16

November 18, 2010

1,363

December 9, 2010

December 15, 2010

0.16

February 17, 2011

1,349

March 10, 2011

The estimate of the amount to be paid as a result of the December 14, 2011 declaration was included in other current liabilities as of December 31, 2011.

NOTE 17 SEGMENT INFORMATION

In its operation of the business, management, including our chief operating decision maker, the Company’s Chief Executive Officer, reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. The segment information within this note is reported on that basis. Our five segments are Windows & Windows Live Division; Server and Tools; Online Services Division; Microsoft Business Division; and Entertainment and Devices Division.

Due to the integrated structure of our business, certain revenue earned and costs incurred by one segment may benefit other segments. Revenue on certain contracts may be allocated among the segments based on the relative value of the underlying products and services. Costs that are identifiable are allocated to the segments that benefit to incent cross-collaboration among our segments so that one segment is not solely burdened by the cost of a mutually beneficial activity. Allocated costs may include those relating to development and marketing of products and services from which multiple segments benefit, or those costs relating to services performed by one segment on behalf of other segments. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated.

In addition, certain costs incurred at a corporate level that are identifiable and that benefit our segments are allocated to them. These allocated costs include costs of: field selling; employee benefits; shared facilities services; and customer service and support. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. Certain other corporate-level activity is not allocated to our segments, including costs of: broad-based sales and marketing; product support services; human resources; legal; finance; information technology; corporate development and procurement activities; research and development; legal settlements and contingencies; and employee severance.

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We have recast certain prior period amounts within this note to conform to the way we internally managed and monitored segment performance during the current fiscal year, including moving Forefront Protection for Office, an anti-malware solution, from Server and Tools to the Microsoft Business Division, as well as conforming management reporting and U.S. GAAP reporting for stock-based compensation.

Segment revenue and operating income (loss) were as follows during the periods presented:


(In millions)	Three Months Ended December 31,						Six Months Ended December 31,


	2011			2010			2011			2010

Revenue
Windows & Windows Live Division	$	4,709		$	4,988		$	9,541		$	9,694
Server and Tools		4,775			4,291			9,026			8,154
Online Services Division		798			729			1,456			1,292
Microsoft Business Division		6,265			5,890			11,855			11,063
Entertainment and Devices Division		4,237			3,728			6,205			5,507
Unallocated and other		101			327			174			438

Consolidated	$	20,885		$	19,953		$	38,257		$	36,148


Operating Income (Loss)
Windows & Windows Live Division	$	2,825		$	3,148		$	6,044		$	6,360
Server and Tools		2,003			1,723			3,608			3,271
Online Services Division		(455	)		(557	)		(968	)		(1,121	)
Microsoft Business Division		4,137			3,865			7,811			7,321
Entertainment and Devices Division		530			706			888			1,088
Reconciling amounts		(1,046	)		(720	)		(2,186	)		(1,638	)

Consolidated	$	7,994		$	8,165		$	15,197		$	15,281

Reconciling amounts in the tables above and below include adjustments to conform our internal accounting policies to U.S. GAAP and corporate-level activity not specifically attributed to a segment. Significant internal accounting policies that differ from U.S. GAAP relate to revenue recognition, income statement classification, and depreciation.

Significant reconciling items were as follows:


(In millions)	Three Months Ended December 31,						Six Months Ended December 31,


	2011			2010			2011			2010

Corporate-level activity^(a)	$	(1,074	)	$	(954	)	$	(2,242	)	$	(1,957	)
Revenue reconciling amounts		24			239			52			347
Other		4			(5	)		4			(28	)

Total	$	(1,046	)	$	(720	)	$	(2,186	)	$	(1,638	)

(a)	Corporate-level activity excludes revenue reconciling amounts presented separately in that line item.

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

PART I

Item 1

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 December 31, 2011, and the related consolidated statements of income, cash flows, and stockholders’ equity for the three-month and six-month periods ended December 31, 2011 and 2010. 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, 2011, and the related consolidated statements of income, cash flows, and stockholders’ equity for the year then ended (not presented herein); and in our report dated July 28, 2011 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, 2011 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/s/ DELOITTE & TOUCHE LLP

Seattle, Washington

January 19, 2012

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Item 2

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Note About Forward-Looking Statements

Certain statements in this report, other than purely historical information, including estimates, projections, statements relating to our business plans, objectives, and expected operating results, and the assumptions upon which those statements are based, are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may appear throughout this report, including without limitation, the following sections: “Management’s Discussion and Analysis,” and “Risk Factors.” These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially from the forward-looking statements. A detailed discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section titled “Risk Factors” (Part II, Item 1A of this Form 10-Q). We undertake no obligation to update or revise publicly any forward-looking statements, whether because of new information, future events, or otherwise.

OVERVIEW

The following management’s discussion and analysis (“MD&A”) is intended to help the reader understand the results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our Annual Report on Form 10-K for the year ended June 30, 2011 and our financial statements and accompanying Notes to Financial Statements.

Microsoft is a technology leader focused on helping people and businesses throughout the world realize their full potential. We create technology that transforms the way people work, play, and communicate across a wide range of computing devices.

We generate revenue by developing, licensing, and supporting a wide range of software products and services, by designing and selling hardware, and by delivering relevant online advertising to a global customer audience. Our most significant expenses are related to compensating employees, designing, manufacturing, marketing and selling our products and services, and income taxes.

Industry Trends

Our industry is dynamic and highly competitive, with frequent changes in both technologies and business models. Each industry shift is an opportunity to conceive new products, new technologies, or new ideas which can further transform the industry and our business. At Microsoft, we push the boundaries of what is possible through a broad set of research and technology innovations that seek to anticipate the changing demands of customers, industry trends, and competitive forces.

Key Opportunities and Investments

Based on our assessment of key technology trends and our broad focus on long-term research and development of new products and services, we see significant opportunities to drive future growth.

Smart connected devices

The price per unit of processing, storage, and networks continues to decline while at the same time devices increase in capability. As a result, the capabilities and accessibility of PCs, mobile, and other devices powered by rich software platforms and applications continue to grow. At the same time, the information and services people use increasingly span multiple devices. User experiences will be transformed by the adoption of cloud computing when brought together with the richness of smart, connected devices. Microsoft is delivering experiences that seamlessly connect PCs and mobile and other devices through the cloud. We are devoting significant resources to consumer cloud offerings like Bing, Windows Live, and Xbox LIVE. Our software and hardware platform investments can be seen in products like Kinect, Windows, Windows Azure, Windows Phone, Windows Server, and Xbox.

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Cloud computing transforming the data center and information technology

Cloud-based solutions provide customers with software, services and content over the Internet by way of shared computing resources located in centralized data centers. Computing is undergoing a long-term shift from client/server to the cloud, a shift similar in importance and impact to the transition from mainframe to client/server. The shift to the cloud is driven by three important economies of scale: larger data centers can deploy computational resources at significantly lower cost per unit than smaller ones; larger data centers can coordinate and aggregate diverse customer, geographic, and application demand patterns which can improve the utilization of computing, storage, and network resources; and multi-tenancy lowers application maintenance labor costs for large public clouds. As a result of the improved economics, the cloud offers unique levels of elasticity and agility that will enable new solutions and applications. For businesses of all sizes, the cloud creates the opportunity to focus more on innovation while leaving non-differentiating activities to reliable and cost-effective providers. For many businesses, the first step in achieving cloud economics is the adoption of virtualization in their data center. We are devoting significant resources to developing cloud infrastructure, platforms, and applications including offerings such as Microsoft Dynamics Online, Microsoft SQL Azure, Office 365, Windows Azure, Windows Intune, and Windows Server.

Entertainment

The evolution of hardware, software, services, and the cloud are enhancing the delivery and quality of unified entertainment experiences across many devices. These rich media experiences include games, movies, music, television, and social interactions with family, friends, and colleagues. At Microsoft, our approach is to simplify and increase the accessibility of these entertainment experiences to broaden market penetration of our software and services. We invest significant resources to develop or partner to develop hardware, software, and content that is used in products and services such as Windows Phone, Xbox, Xbox LIVE, and Skype.

Search

Over the last two decades, web content and social connections have increased dramatically as people spend more time online, while discoverability and accessibility has been transforming from direct navigation and document links. There is significant opportunity to deliver differentiated products that helps users make better decisions and complete tasks more simply when using PC, mobile, and other devices. Our approach is to use machine learning to try to understand user intent, and differentiate our product by focusing on the integration of visual, social, and other elements which simplifies people’s interaction with the Internet. We invest significant resources in Bing, SharePoint, Windows, Windows Phone, and Xbox LIVE.

Communications and productivity

Personal and business productivity has been transformed by the ubiquity of computing and software tools. Over the last decade, Microsoft redefined software productivity beyond the rich Office client on the PC. Productivity scenarios now encompass unified communications, business intelligence, collaboration, content management, and relationship management, which are increasingly powered by server-side applications. These server applications can be hosted by the customer, a partner, or by Microsoft in the cloud. There are significant opportunities to provide productivity and communication scenarios across PCs, mobile devices, and other devices that connect to services. We invest significant resources in Dynamics, Exchange, Lync, Skype, Office, Office 365, SharePoint, and Windows Live.

Economic Conditions, Challenges and Risks

As discussed above, our industry is dynamic and highly competitive. We must anticipate changes in technology and business models. Our model for growth is based on our ability to initiate and embrace disruptive technology trends, to enter new markets, both in terms of geographies and product areas, and to drive broad adoption of the products and services we develop and market.

At Microsoft, we prioritize our investments among the highest long-term growth opportunities. These investments require significant resources and are multi-year in nature. The products and services we bring to market can be built internally, brought to market as part of a partnership or alliance, or through acquisition.

Our success is highly dependent on our ability to attract and retain qualified employees. We rely on hiring from a mix of university and industry talent worldwide. Microsoft competes for talented individuals worldwide by offering broad customer reach, scale in resources, and competitive compensation.

PART I

Item 2

Demand for our software, services, and hardware has a strong correlation to global macroeconomic factors. The current macroeconomic factors remain dynamic. See a discussion of these factors and other risks under Risk Factors (Part II, Item 1A. of this Form 10-Q).

Seasonality

Our revenue historically has fluctuated quarterly and has generally been the highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers. Our Entertainment and Devices Division is particularly seasonal as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Typically, the Entertainment and Devices Division has generated approximately 40% of its yearly segment revenue in our second fiscal quarter. In addition, quarterly revenue may be impacted by the deferral of revenue. See the discussions below regarding sales of earlier versions of the Microsoft Office system with a guarantee to be upgraded to the newest version of the Microsoft Office system at minimal or no cost (the “Office Deferral”).

RESULTS OF OPERATIONS

Summary


(In millions, except percentages and per share amounts)	Three Months Ended December 31,				Percentage Change		Six Months Ended December 31,				Percentage Change


	2011		2010				2011		2010

Revenue	$	20,885	$	19,953		5%	$	38,257	$	36,148		6%
Operating income	$	7,994	$	8,165		(2)%	$	15,197	$	15,281		(1)%
Diluted earnings per share	$	0.78	$	0.77		1%	$	1.46	$	1.39		5%

Three months ended December 31, 2011 compared with three months ended December 31, 2010

Revenue increased primarily due to strong sales of Server and Tools products, the Xbox 360 entertainment platform, and the 2010 Microsoft Office system, offset in part by a decline in sales of PCs to consumers. Revenue for the three months ended December 31, 2011 also included Skype revenue from the date of acquisition and a favorable foreign currency impact of $225 million.

Operating income decreased reflecting higher operating expenses, offset in part by revenue growth. Key changes in operating expenses were:

•

Cost of revenue increased $805 million or 17%, primarily reflecting higher volumes of Xbox 360 consoles sold and increased Xbox royalty costs, higher costs associated with providing Server and Tools products and services, payments made to Nokia related to joint strategic initiatives, and increased costs associated with our online offerings, including traffic acquisition costs.

•

Research and development expenses increased $186 million or 9%, due mainly to higher headcount-related expenses.

•

General and administrative expenses increased $175 million or 19%, due mainly to Puerto Rican excise taxes, higher headcount-related expenses, and increased legal costs.

Headcount-related expenses increased across the company reflecting annual increases in pay and bonuses, changes in our employee compensation program, and a 4% increase in headcount from December 31, 2010. Diluted earnings per share increased reflecting increased net income and the repurchase of 174 million shares during the 12 months ended December 31, 2011.

Six months ended December 31, 2011 compared with six months ended December 31, 2010

Revenue increased primarily due to strong sales of Server and Tools products, the Xbox 360 entertainment platform, and the 2010 Microsoft Office system, offset in part by a decline in sales of PCs to consumers. Revenue for the six months ended December 31, 2011 also included Skype revenue from the date of acquisition and a favorable foreign currency impact of $635 million.

PART I

Item 2

Operating income decreased slightly reflecting higher operating expenses, offset in part by revenue growth. Key changes in operating expenses were:

•

Cost of revenue increased $1.4 billion or 18%, primarily due to higher Xbox royalty costs, higher costs associated with providing Server and Tools products and services, increased costs associated with our online offerings, including traffic acquisition costs, and payments made to Nokia related to joint strategic initiatives.

•

General and administrative expenses increased $400 million or 21%, due mainly to Puerto Rican excise taxes, higher headcount-related expenses, and increased legal costs.

•

Research and development expenses increased $319 million or 7%, due mainly to higher headcount-related expenses.

SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS)

The revenue and operating income (loss) amounts in this section are presented on a basis consistent with accounting principles generally accepted in the U.S. (“U.S. GAAP”) and include certain reconciling items attributable to each of the segments. Segment information appearing in Note 17 – Segment Information of the Notes to Financial Statements (Part I, Item I of this Form 10-Q) is presented on a basis consistent with our current internal management reporting. Certain corporate-level activity has been excluded from segment operating results and is analyzed separately. We have recast certain prior period amounts within this MD&A to conform to the way we internally managed and monitored segment performance during the current fiscal year, including moving Forefront Protection for Office, an anti-malware solution, from Server and Tools to the Microsoft Business Division.

Windows & Windows Live Division


(In millions, except percentages)	Three Months Ended December 31,				Percentage Change		Six Months Ended December 31,				Percentage Change


	2011		2010				2011		2010

Revenue	$	4,736	$	5,056		(6)%	$	9,604	$	9,843		(2)%
Operating income	$	2,850	$	3,214		(11)%	$	6,101	$	6,502		(6)%

Windows & Windows Live Division (“Windows Division”) develops and markets PC operating systems, related software and online services, and PC hardware products. This collection of software, hardware, and services is designed to simplify everyday tasks through efficient browsing capabilities and seamless operations across the user’s hardware and software. Windows Division offerings consist of multiple editions of the Windows operating system, software and services through Windows Live, and Microsoft PC hardware products.

Windows Division revenue is largely correlated to the PC market worldwide, as approximately 75% of total Windows Division revenue comes from Windows operating system software purchased by original equipment manufacturers (“OEMs”) which they pre-install on equipment they sell. The remaining approximately 25% of Windows Division revenue is generated by commercial and retail sales of Windows and PC hardware products and online advertising from Windows Live.

Three months ended December 31, 2011 compared with three months ended December 31, 2010

Windows Division revenue reflected relative performance in PC market segments. We estimate that sales of PCs to businesses grew approximately 2% and sales of PCs to consumers declined approximately 6%. Excluding a decline in sales of netbooks, we estimate that sales of PCs to consumers grew approximately 2%. Taken together, the total PC market decreased an estimated 2% to 4%, including the impact of supply chain issues from the Thailand floods. Windows Division revenue was also negatively impacted by a reduction in inventory levels within our distribution channels as well as by the effect of higher growth in emerging markets, where average selling prices are lower, relative to developed markets, and by lower recognition of previously deferred Windows XP revenue.

PART I

Item 2

Windows Division operating income decreased primarily because of lower revenue and higher research and development expenses. Research and development expenses increased due mainly to an increase in headcount-related costs and product development costs associated with the next version of the Windows operating system.

Six months ended December 31, 2011 compared with six months ended December 31, 2010

Windows Division revenue reflected relative performance in PC market segments. We estimate that sales of PCs to businesses grew approximately 5% and sales of PCs to consumers declined approximately 2%. Excluding a decline in sales of netbooks, we estimate that sales of PCs to consumers grew approximately 5%. Taken together, the total PC market remained flat. Windows Division revenue was negatively impacted by higher growth in emerging markets, where average selling prices are lower, relative to developed markets, and by lower recognition of previously deferred Windows XP revenue.

Windows Division operating income decreased because of lower revenue and higher operating expenses, primarily research and development expenses associated with the next version of the Windows operating system.

Server and Tools


(In millions, except percentages)	Three Months Ended December 31,				Percentage Change		Six Months Ended December 31,				Percentage Change


	2011		2010				2011		2010

Revenue	$	4,772	$	4,288		11%	$	9,022	$	8,149		11%
Operating income	$	1,996	$	1,711		17%	$	3,593	$	3,248		11%

Server and Tools develops and markets technology and related services that enable information technology professionals and their systems to be more productive and efficient. Server and Tools product and service offerings include Windows Server, Microsoft SQL Server, Windows Azure, Visual Studio, System Center products, Windows Embedded device platforms, and Enterprise Services. Enterprise Services comprise Premier product support services and Microsoft Consulting Services. We also offer developer tools, training and certification. Approximately 50% of Server and Tools revenue comes primarily from multi-year volume licensing agreements, approximately 30% is purchased through transactional volume licensing programs, retail packaged product and licenses sold to OEMs, and the remainder comes from Enterprise Services.

Three months ended December 31, 2011 compared with three months ended December 31, 2010

Server and Tools revenue increased reflecting growth in both product sales and Enterprise Services. Product revenue increased $328 million or 10%, driven primarily by growth in SQL Server, Windows Server, Enterprise CAL Suites, and System Center, reflecting continued adoption of Windows platform applications. Enterprise Services revenue grew in both Premier product support and consulting services.

Server and Tools operating income increased primarily due to revenue growth, offset in part by higher costs of providing products and services.

Six months ended December 31, 2011 compared with six months ended December 31, 2010

Server and Tools revenue increased $873 million or 11%, reflecting growth in SQL Server, Windows Server, Enterprise CAL Suites, System Center, and Enterprise Services. Server and Tools revenue for the six months ended December 31, 2011 included a favorable foreign currency impact of $170 million.

PART I

Item 2

Server and Tools operating income increased due to revenue growth, offset in part by higher costs of providing products and services.

Online Services Division


(In millions, except percentages)	Three Months Ended December 31,						Percentage Change		Six Months Ended December 31,						Percentage Change


	2011			2010					2011			2010

Revenue	$	784		$	713			10%	$	1,425		$	1,260			13%
Operating loss	$	(458	)	$	(559	)		18%	$	(971	)	$	(1,132	)		14%

Online Services Division (“OSD”) develops and markets information and content designed to help people simplify tasks and make more informed decisions online, and that help advertisers connect with audiences. OSD offerings include Bing, MSN, adCenter, and advertiser tools. Bing and MSN generate revenue through the sale of search and display advertising. Search and display advertising accounts for nearly all of OSD’s annual revenue.

Three months ended December 31, 2011 compared with three months ended December 31, 2010

OSD revenue increased primarily as a result of growth in online advertising revenue. Online advertising revenue grew $81 million or 13% to $713 million, reflecting continued growth in search and display advertising revenue, offset in part by decreased third party display advertising revenue. As of December 31, 2011, according to third-party sources, Bing organic U.S. market share grew over 25% from December 31, 2010 to approximately 15%. Bing-powered U.S. market share, including Yahoo! properties, grew over 9% during this same period to approximately 27%.

OSD operating loss decreased due primarily to higher revenue and lower sales and marketing expenses, offset in part by increased cost of revenue.

Six months ended December 31, 2011 compared with six months ended December 31, 2010

OSD revenue increased primarily as a result of growth in online advertising revenue. Online advertising revenue grew $181 million or 16% to $1.3 billion, reflecting continued growth in search and display advertising revenue, offset in part by decreased third party display advertising revenue. As of December 31, 2011, according to third-party sources, Bing organic U.S. market share grew over 25% from December 31, 2010 to approximately 15%. Bing-powered U.S. market share, including Yahoo! properties, grew over 9% during this same period to approximately 27%.

OSD operating loss decreased due primarily to higher revenue and lower sales and marketing expenses, offset in part by increased cost of revenue.

Microsoft Business Division

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