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, 2012

¨	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 18, 2013


Common Stock, $0.00000625 par value per share		8,376,244,910 shares

MICROSOFT CORPORATION

FORM 10-Q

For the Quarter Ended December 31, 2012

INDEX


				Page
PART I.	FINANCIAL INFORMATION

	Item 1.	Financial Statements

		a)	Income Statements for the Three and Six Months Ended December 31, 2012 and 2011		3

		b)	Comprehensive Income Statements for the Three and Six Months Ended December 31, 2012 and 2011		4

		c)	Balance Sheets as of December 31, 2012 and June 30, 2012		5

		d)	Cash Flows Statements for the Three and Six Months Ended December 31, 2012 and 2011		6

		e)	Stockholders’ Equity Statements for the Three and Six Months Ended December 31, 2012 and 2011		7

		f)	Notes to Financial Statements		8

		g)	Report of Independent Registered Public Accounting Firm		30

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations			31

	Item 3.	Quantitative and Qualitative Disclosures About Market Risk			48

	Item 4.	Controls and Procedures			49

PART II.	OTHER INFORMATION

	Item 1.	Legal Proceedings			49

	Item 1A.	Risk Factors			49

	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds			56

	Item 6.	Exhibits			57

SIGNATURE					58

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,


	2012			2011		2012		2011

Revenue	$	21,456		$	20,885	$	37,464	$	38,257
Cost of revenue		5,692			5,638		9,860		9,415

Gross profit		15,764			15,247		27,604		28,842
Operating expenses:
Research and development		2,528			2,371		4,988		4,700
Sales and marketing		4,309			3,762		7,254		6,662
General and administrative		1,156			1,120		2,283		2,283

Total operating expenses		7,993			7,253		14,525		13,645

Operating income		7,771			7,994		13,079		15,197
Other income (expense)		(1	)		245		225		348

Income before income taxes		7,770			8,239		13,304		15,545
Provision for income taxes		1,393			1,615		2,461		3,183

Net income	$	6,377		$	6,624	$	10,843	$	12,362


Earnings per share:
Basic	$	0.76		$	0.79	$	1.29	$	1.47
Diluted	$	0.76		$	0.78	$	1.28	$	1.46

Weighted average shares outstanding:
Basic		8,393			8,402		8,395		8,397
Diluted		8,444			8,465		8,480		8,489

Cash dividends declared per common share	$	0.23		$	0.20	$	0.46	$	0.40

See accompanying notes.

PART I

Item 1

COMPREHENSIVE INCOME STATEMENTS


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


	2012			2011			2012			2011

Net income	$	6,377		$	6,624		$	10,843		$	12,362
Other comprehensive income (loss):
Net unrealized gains (losses) on derivatives (net of tax effects of $(5), $41, $(29), and $127)		(9	)		76			(54	)		236
Net unrealized gains (losses) on investments (net of tax effects of $103, $67, $251, and $(552))		192			124			466			(1,025	)
Translation adjustments and other (net of tax effects of $2, $(67), $92 and $(134))		3			(125	)		172			(248	)

Other comprehensive income (loss)		186			75			584			(1,037	)

Comprehensive income	$	6,563		$	6,699		$	11,427		$	11,325

See accompanying notes.

PART I

Item 1

BALANCE SHEETS


(In millions) (Unaudited)


December 31, 2012				June 30, 2012

Assets
Current assets:
Cash and cash equivalents	$	6,017	$	6,938
Short-term investments (including securities loaned of $7 and $785)		62,295		56,102

Total cash, cash equivalents, and short-term investments		68,312		63,040
Accounts receivable, net of allowance for doubtful accounts of $292 and $389		14,317		15,780
Inventories		1,661		1,137
Deferred income taxes		1,983		2,035
Other		3,301		3,092

Total current assets		89,574		85,084
Property and equipment, net of accumulated depreciation of $11,773 and $10,962		8,698		8,269
Equity and other investments		10,707		9,776
Goodwill		14,727		13,452
Intangible assets, net		3,341		3,170
Other long-term assets		1,636		1,520

Total assets	$	128,683	$	121,271

Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	$	4,356	$	4,175
Current portion of long-term debt		2,241		1,231
Accrued compensation		2,942		3,875
Income taxes		630		789
Short-term unearned revenue		18,354		18,653
Securities lending payable		21		814
Other		3,366		3,151

Total current liabilities		31,910		32,688
Long-term debt		11,947		10,713
Long-term unearned revenue		1,459		1,406
Deferred income taxes		2,394		1,893
Other long-term liabilities		8,397		8,208

Total liabilities		56,107		54,908

Commitments and contingencies
Stockholders’ equity:
Common stock and paid-in capital—shares authorized 24,000; outstanding 8,374 and 8,381		66,334		65,797
Retained earnings (deficit)		4,236		(856	)
Accumulated other comprehensive income		2,006		1,422

Total stockholders’ equity		72,576		66,363

Total liabilities and stockholders’ equity	$	128,683	$	121,271

See accompanying notes.

PART I

Item 1

CASH FLOWS STATEMENTS


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


	2012			2011			2012			2011

Operations
Net income	$	6,377		$	6,624		$	10,843		$	12,362
Adjustments to reconcile net income to net cash from operations:
Depreciation, amortization, and other		1,009			678			1,719			1,404
Stock-based compensation expense		603			575			1,206			1,133
Net recognized losses (gains) on investments and derivatives		22			(112	)		33			(142	)
Excess tax benefits from stock-based compensation		(9	)		(4	)		(186	)		(74	)
Deferred income taxes		140			14			178			416
Deferral of unearned revenue		10,737			7,544			18,946			13,683
Recognition of unearned revenue		(10,483	)		(8,057	)		(19,253	)		(15,710	)
Changes in operating assets and liabilities:
Accounts receivable		(4,488	)		(3,652	)		1,668			1,081
Inventories		(33	)		891			(506	)		(29	)
Other current assets		150			605			(235	)		865
Other long-term assets		(80	)		30			(313	)		(45	)
Accounts payable		685			176			118			(266	)
Other current liabilities		168			394			(1,119	)		(599	)
Other long-term liabilities		(18	)		156			165			276

Net cash from operations		4,780			5,862			13,264			14,355

Financing
Proceeds from issuance of debt		2,232			0			2,232			0
Common stock issued		145			208			562			544
Common stock repurchased		(1,658	)		(1,042	)		(3,290	)		(2,976	)
Common stock cash dividends paid		(1,933	)		(1,683	)		(3,609	)		(3,024	)
Excess tax benefits from stock-based compensation		9			4			186			74
Other		(16	)		0			(16	)		0

Net cash used in financing		(1,221	)		(2,513	)		(3,935	)		(5,382	)

Investing
Additions to property and equipment		(930	)		(498	)		(1,533	)		(934	)
Acquisition of companies, net of cash acquired, and purchases of intangible and other assets		(311	)		(8,627	)		(1,456	)		(9,502	)
Purchases of investments		(10,074	)		(10,047	)		(30,212	)		(21,346	)
Maturities of investments		1,989			6,061			3,248			8,886
Sales of investments		7,126			7,835			20,433			15,371
Securities lending payable		(393	)		(292	)		(792	)		(358	)

Net cash used in investing		(2,593	)		(5,568	)		(10,312	)		(7,883	)

Effect of exchange rates on cash and cash equivalents		15			(52	)		62			(90	)

Net change in cash and cash equivalents		981			(2,271	)		(921	)		1,000
Cash and cash equivalents, beginning of period		5,036			12,881			6,938			9,610

Cash and cash equivalents, end of period	$	6,017		$	10,610		$	6,017		$	10,610

See accompanying notes.

PART I

Item 1

STOCKHOLDERS’ EQUITY STATEMENTS


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


	2012			2011			2012			2011

Common stock and paid-in capital
Balance, beginning of period	$	66,084		$	63,492		$	65,797		$	63,415
Common stock issued		145			208			552			544
Common stock repurchased		(507	)		(340	)		(1,398	)		(1,164	)
Stock-based compensation expense		603			575			1,206			1,133
Stock-based compensation income tax benefits (deficiencies)		5			(35	)		172			(29	)
Other, net		4			2			5			3

Balance, end of period		66,334			63,902			66,334			63,902

Retained earnings (deficit)
Balance, beginning of period		932			(4,852	)		(856	)		(8,195	)
Net income		6,377			6,624			10,843			12,362
Common stock cash dividends		(1,922	)		(1,677	)		(3,859	)		(3,360	)
Common stock repurchased		(1,151	)		(702	)		(1,892	)		(1,414	)

Balance, end of period		4,236			(607	)		4,236			(607	)

Accumulated other comprehensive income
Balance, beginning of period		1,820			751			1,422			1,863
Other comprehensive income (loss)		186			75			584			(1,037	)

Balance, end of period		2,006			826			2,006			826

Total stockholders’ equity	$	72,576		$	64,121		$	72,576		$	64,121

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, comprehensive 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 2012 Form 10-K filed on July 26, 2012 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 of estimates include: loss contingencies; product warranties; the fair value of, and/or potential goodwill impairment for, our reporting units; product life cycles; useful lives of our tangible and intangible assets; allowances for doubtful accounts; allowances for product returns; and stock-based compensation forfeiture rates. Examples of assumptions include: the elements comprising a software arrangement, including the distinction between upgrades or enhancements and new products; when technological feasibility is achieved for our products; the potential outcome of future tax consequences of events that have been recognized in our financial statements or tax returns; and determining when investment impairments are other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions.

Recasting of Certain Prior Period Information

We have recast certain prior period amounts to conform to the current period presentation, including the reclassification of accumulated other comprehensive income from retained earnings to a separate component of stockholders’ equity, the reclassification of cost of revenue from operating expenses to a separate line and the addition of a gross profit line in the income statements, and the recasting of segment information for immaterial movements of business activities between segments and changes in cost allocations, with no impact on consolidated net income or cash flows.

Recently Adopted Accounting Guidance

In September 2011, the Financial Accounting Standards Board (“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. We adopted this new guidance beginning July 1, 2012. Adoption of this new guidance did not have a material impact on our financial statements.

In June 2011, the FASB issued guidance on presentation of comprehensive income. The new guidance eliminated the option to report other comprehensive income and its components in the statement of changes in stockholders’ equity. Instead, an entity is 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

PART I

Item 1

which net income is presented and the statement in which other comprehensive income is presented. This guidance was amended in December 2011 when the FASB issued guidance which indefinitely defers presentation of reclassification adjustments. We adopted this new amended guidance beginning July 1, 2012. Adoption of this new amended guidance resulted only in changes to presentation of 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.

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,


	2012		2011		2012		2011

Net income available for common shareholders (A)	$	6,377	$	6,624	$	10,843	$	12,362

Weighted average outstanding shares of common stock (B)		8,393		8,402		8,395		8,397
Dilutive effect of stock-based awards		51		63		85		92

Common stock and common stock equivalents (C)		8,444		8,465		8,480		8,489

Earnings Per Share
Basic (A/B)	$	0.76	$	0.79	$	1.29	$	1.47
Diluted (A/C)	$	0.76	$	0.78	$	1.28	$	1.46

Anti-dilutive stock-based awards excluded from the calculations of diluted EPS were immaterial during the periods presented.

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, 2012, none of these securities had met price or other conditions that would make them eligible for conversion and therefore were excluded from the calculation of basic and diluted EPS. See Note 11 – Debt for additional information.

PART I

Item 1

NOTE 3 OTHER INCOME (EXPENSE)

The components of other income (expense) were as follows:


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


	2012			2011			2012			2011

Dividends and interest income	$	166		$	182		$	325		$	393
Interest expense		(105	)		(95	)		(200	)		(189	)
Net recognized gains on investments		43			315			28			318
Net losses on derivatives		(65	)		(203	)		(61	)		(176	)
Net losses on foreign currency remeasurements		(7	)		(4	)		(36	)		(44	)
Other		(33	)		50			169			46

Total	$	(1	)	$	245		$	225		$	348

Other income for the six months ended December 31, 2012 included a gain recognized upon the divestiture of our 50% share in the MSNBC joint venture on July 13, 2012.

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


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


	2012			2011			2012			2011

Other-than-temporary impairments of investments	$	(40	)	$	(107	)	$	(130	)	$	(152	)
Realized gains from sales of available-for-sale securities		109			643			210			843
Realized losses from sales of available-for-sale securities		(26	)		(221	)		(52	)		(373	)

Total	$	43		$	315		$	28		$	318

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, 2012

Cash	$	2,376	$	0	$	0		$	2,376	$	2,376	$	0	$	0
Mutual funds		2,630		0		0			2,630		2,630		0		0
Commercial paper		13		0		0			13		13		0		0
Certificates of deposit		517		0		0			517		335		182		0
U.S. government and agency securities		54,202		131		(2	)		54,331		12		54,319		0
Foreign government bonds		974		29		(24	)		979		0		979		0
Mortgage-backed securities		1,554		69		(1	)		1,622		0		1,622		0
Corporate notes and bonds		5,135		282		(5	)		5,412		651		4,761		0
Municipal securities		358		61		0			419		0		419		0
Common and preferred stock		7,016		2,586		(176	)		9,426		0		0		9,426
Other investments		1,294		0		0			1,294		0		13		1,281

Total	$	76,069	$	3,158	$	(208	)	$	79,019	$	6,017	$	62,295	$	10,707

PART I

Item 1


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


June 30, 2012

Cash	$	2,019	$	0	$	0		$	2,019	$	2,019	$	0	$	0
Mutual funds		820		0		0			820		820		0		0
Commercial paper		96		0		0			96		96		0		0
Certificates of deposit		744		0		0			744		342		402		0
U.S. government and agency securities		47,178		130		(2	)		47,306		561		46,745		0
Foreign government bonds		1,741		18		(29	)		1,730		575		1,155		0
Mortgage-backed securities		1,816		82		(2	)		1,896		0		1,896		0
Corporate notes and bonds		7,799		224		(15	)		8,008		2,525		5,483		0
Municipal securities		358		58		0			416		0		416		0
Common and preferred stock		6,965		2,204		(436	)		8,733		0		0		8,733
Other investments		1,048		0		0			1,048		0		5		1,043

Total	$	70,584	$	2,716	$	(484	)	$	72,816	$	6,938	$	56,102	$	9,776

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


December 31, 2012

U.S. government and agency securities	$	337	$	(2	)	$	0	$	0		$	337	$	(2	)
Foreign government bonds		158		(1	)		119		(23	)		277		(24	)
Mortgage-backed securities		53		0			45		(1	)		98		(1	)
Corporate notes and bonds		232		(2	)		27		(3	)		259		(5	)
Common and preferred stock		1,063		(116	)		450		(60	)		1,513		(176	)

Total	$	1,843	$	(121	)	$	641	$	(87	)	$	2,484	$	(208	)


	Less than 12 Months					12 Months or Greater					Total Fair Value		Total Unrealized Losses
(In millions)	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Total Fair Value		Total Unrealized Losses


June 30, 2012

U.S. government and agency securities	$	44	$	(2	)	$	0	$	0		$	44	$	(2	)
Foreign government bonds		657		(27	)		12		(2	)		669		(29	)
Mortgage-backed securities		53		0			48		(2	)		101		(2	)
Corporate notes and bonds		640		(11	)		70		(4	)		710		(15	)
Common and preferred stock		2,135		(329	)		305		(107	)		2,440		(436	)

Total	$	3,529	$	(369	)	$	435	$	(115	)	$	3,964	$	(484	)

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, 2012.

PART I

Item 1

At December 31, 2012 and June 30, 2012, 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 $360 million and $313 million, respectively. These investments are carried at cost and are reviewed quarterly for indicators of other-than-temporary impairment. It is not possible for us to reliably estimate the fair value of these investments.

Debt Investment Maturities


(In millions)	Cost Basis		Estimated Fair Value


December 31, 2012

Due in one year or less	$	26,378	$	26,403
Due after one year through five years		30,848		30,972
Due after five years through 10 years		3,272		3,525
Due after 10 years		2,255		2,393

Total	$	62,753	$	63,293

NOTE 5 DERIVATIVES

We use derivative instruments to: manage risks related to foreign currencies, equity prices, interest rates, and credit; enhance investment returns; and 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, 2012 and June 30, 2012, the total notional amounts of these foreign exchange contracts sold were $4.8 billion and $6.7 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, 2012 and June 30, 2012, the total notional amounts of these foreign exchange contracts sold were $590 million and $1.3 billion, 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, 2012, the total notional amounts of these foreign exchange contracts purchased and sold were $3.6 billion and $6.2 billion, respectively. As of June 30, 2012, the total notional amounts of these foreign exchange contracts purchased and sold were $3.6 billion and $7.3 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, 2012, the total notional amounts of designated and non-designated equity contracts purchased and sold were $954 million and $641 million, respectively. As of June 30, 2012, the total notional amounts of designated and non-designated equity contracts purchased and sold were $1.4 billion and $982 million, respectively.

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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, 2012, the total notional amounts of fixed-interest rate contracts purchased and sold were $1.2 billion and $1.8 billion, respectively. As of June 30, 2012, the total notional amounts of fixed-interest rate contracts purchased and sold were $3.2 billion and $1.9 billion, 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, 2012 and June 30, 2012, the total notional derivative amounts of mortgage contracts purchased were $1.2 billion and $1.1 billion, 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, 2012, the total notional amounts of credit contracts purchased and sold were $355 million and $465 million, respectively. As of June 30, 2012, the total notional amounts of credit contracts purchased and sold were $318 million and $456 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, 2012, the total notional amounts of commodity contracts purchased and sold were $1.4 billion and $396 million, respectively. As of June 30, 2012, the total notional amounts of commodity contracts purchased and sold were $1.5 billion and $445 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, 2012, 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 gains (losses) are recognized in earnings in the periods of change together with the offsetting losses (gains) 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 gains (losses) on the derivatives 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.

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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, 2012

Assets
Non-designated hedge derivatives:
Short-term investments	$	22		$	144		$	8		$	13		$	3	$	190
Other current assets		53			0			0			0			0		53

Total	$	75		$	144		$	8		$	13		$	3	$	243
Designated hedge derivatives:
Short-term investments	$	25		$	0		$	0		$	0		$	0	$	25
Other current assets		74			0			0			0			0		74

Total	$	99		$	0		$	0		$	0		$	0	$	99

Total assets	$	174		$	144		$	8		$	13		$	3	$	342

Liabilities
Non-designated hedge derivatives:
Other current liabilities	$	(78	)	$	(6	)	$	(9	)	$	(18	)	$	0	$	(111	)
Designated hedge derivatives:
Other current liabilities	$	(5	)	$	0		$	0		$	0		$	0	$	(5	)

Total liabilities	$	(83	)	$	(6	)	$	(9	)	$	(18	)	$	0	$	(116	)

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


June 30, 2012

Assets
Non-designated hedge derivatives:
Short-term investments	$	14		$	162		$	10		$	26		$	3	$	215
Other current assets		85			0			0			0			0		85

Total	$	99		$	162		$	10		$	26		$	3	$	300
Designated hedge derivatives:
Short-term investments	$	6		$	0		$	0		$	0		$	0	$	6
Other current assets		177			0			0			0			0		177

Total	$	183		$	0		$	0		$	0		$	0	$	183

Total assets	$	282		$	162		$	10		$	26		$	3	$	483

Liabilities
Non-designated hedge derivatives:
Other current liabilities	$	(84	)	$	(19	)	$	(17	)	$	(21	)	$	0	$	(141	)
Designated hedge derivatives:
Other current liabilities	$	(14	)	$	0		$	0		$	0		$	0	$	(14	)

Total liabilities	$	(98	)	$	(19	)	$	(17	)	$	(21	)	$	0	$	(155	)

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

Fair-Value Hedge Gains (Losses)

We recognized in other income (expense) 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,


	2012			2011			2012			2011

Foreign Exchange Contracts
Derivatives	$	35		$	4		$	23		$	48
Hedged items		(35	)		(5	)		(21	)		(48	)

Total	$	0		$	(1	)	$	2		$	0

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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,


	2012			2011			2012			2011

Effective Portion
Gains (losses) recognized in OCI, net of tax effect of $7 and $33 for the three months ended December 31, 2012 and 2011, and $(5) and $102 for the six months ended December 31, 2012 and 2011	$	13		$	62		$	(10	)	$	190
Gains (losses) reclassified from OCI into revenue		34			(21	)		69			(70	)
Amount Excluded from Effectiveness Assessment and Ineffective Portion
Losses recognized in other income (expense)		(36	)		(127	)		(107	)		(65	)

We estimate that $63 million of net derivative gains included in OCI at December 31, 2012 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, 2012.

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,


	2012			2011			2012			2011

Foreign exchange contracts	$	(12	)	$	(16	)	$	(25	)	$	(65	)
Equity contracts		15			(79	)		17			(68	)
Interest-rate contracts		1			15			19			58
Credit contracts		(2	)		10			(9	)		(7	)
Commodity contracts		(45	)		2			21			(88	)

Total	$	(43	)	$	(68	)	$	23		$	(170	)

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

PART I

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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 and goodwill when it is recorded at fair value due to an impairment charge. We value the Level 3 corporate bonds using internally developed valuation models, inputs to which include interest rate curves, credit spreads, stock prices, and volatilities. 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. Unobservable inputs used in all of these models are significant to the fair values of the assets and liabilities.

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.

Our other current financial assets and our current financial liabilities have fair values that approximate their carrying values.

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, 2012

Assets
Mutual funds	$	2,630	$	0	$	0	$	2,630	$	0		$	2,630
Commercial paper		0		13		0		13		0			13
Certificates of deposit		0		517		0		517		0			517
U.S. government and agency securities		51,443		2,887		0		54,330		0			54,330
Foreign government bonds		47		907		0		954		0			954
Mortgage-backed securities		0		1,624		0		1,624		0			1,624
Corporate notes and bonds		0		5,249		18		5,267		0			5,267
Municipal securities		0		419		0		419		0			419
Common and preferred stock		8,290		772		5		9,067		0			9,067
Derivatives		10		332		0		342		(101	)		241

Total	$	62,420	$	12,720	$	23	$	75,163	$	(101	)	$	75,062

Liabilities
Derivatives and other	$	4	$	112	$	0	$	116	$	(101	)	$	15

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


June 30, 2012

Assets
Mutual funds	$	820	$	0	$	0	$	820	$	0		$	820
Commercial paper		0		96		0		96		0			96
Certificates of deposit		0		744		0		744		0			744
U.S. government and agency securities		42,291		5,019		0		47,310		0			47,310
Foreign government bonds		31		1,703		0		1,734		0			1,734
Mortgage-backed securities		0		1,892		0		1,892		0			1,892
Corporate notes and bonds		0		7,839		9		7,848		0			7,848
Municipal securities		0		416		0		416		0			416
Common and preferred stock		7,539		877		5		8,421		0			8,421
Derivatives		16		467		0		483		(141	)		342

Total	$	50,697	$	19,053	$	14	$	69,764	$	(141	)	$	69,623

Liabilities
Derivatives and other	$	10	$	145	$	0	$	155	$	(139	)	$	16

(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.

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, 2012			June 30, 2012

Net fair value of assets measured at fair value on a recurring basis	$	75,062		$	69,623
Cash		2,376			2,019
Common and preferred stock measured at fair value on a nonrecurring basis		360			313
Other investments measured at fair value on a nonrecurring basis		1,281			1,043
Less derivative net assets classified as other current assets		(63	)		(185	)
Other		3			3

Recorded basis of investment components	$	79,019		$	72,816

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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, 2012

Balance as of June 30, 2012	$	9	$	5	$	0	$	14
Realized and unrealized gains (losses):
Included in other income (expense)		0		0		0		0
Included in other comprehensive income (loss)		0		0		0		0
Purchases		8		0		0		8

Balance as of September 30, 2012	$	17	$	5	$	0	$	22
Realized and unrealized gains (losses):
Included in other income (expense)		0		0		0		0
Included in other comprehensive income		1		0		0		1

Balance as of December 31, 2012	$	18	$	5	$	0	$	23

Change in unrealized gains (losses) included in other income (expense) for the three months ended December 31, 2012 related to assets held as of December 31, 2012	$	0	$	0	$	0	$	0
Change in unrealized gains (losses) included in other income (expense) for the six months ended December 31, 2012 related to assets held as of December 31, 2012	$	0	$	0	$	0	$	0


(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
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
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

Financial Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

During the three and six months ended December 31, 2012 and 2011, we did not record any material other-than-temporary impairments on financial assets required to be measured at fair value on a nonrecurring basis.

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NOTE 7 INVENTORIES

The components of inventories were as follows:


(In millions)


December 31, 2012			June 30, 2012

Raw materials	$	646	$	210
Work in process		76		96
Finished goods		939		831

Total	$	1,661	$	1,137

NOTE 8 BUSINESS COMBINATIONS

Yammer

On July 18, 2012, we acquired Yammer, Inc. (“Yammer”), a leading provider of enterprise social networks, for $1.1 billion in cash. Yammer will continue to develop its standalone service and will add an enterprise social networking service to Microsoft’s portfolio of complementary cloud-based services. The major classes of assets to which we allocated the purchase price were goodwill of $937 million and identifiable intangible assets of $178 million. We assigned the goodwill to the Microsoft Business Division. Yammer was consolidated into our results of operations starting on the acquisition date.

Following are details of the purchase price allocated to the intangible assets acquired:


(In millions)			Weighted Average Life


Customer-related	$	77		6 years
Technology-based		67		4 years
Marketing-related		34		7 years

Total	$	178		5 years

Other

During the six months ended December 31, 2012, we completed five additional acquisitions for total consideration of $384 million, all of which was paid in cash. These entities have been included in our consolidated results of operations since their respective acquisition dates.

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, 2012		Acquisitions		Other			Balance as of December 31, 2012


Windows Division	$	89	$	0	$	0		$	89
Server and Tools		1,144		211		0			1,355
Online Services Division		223		0		0			223
Microsoft Business Division		7,903		6		23			7,932
Entertainment and Devices Division		5,107		27		(6	)		5,128

Total	$	14,466	$	244	$	17		$	14,727

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(In millions)	Balance as of June 30, 2012		Acquisitions		Other			Balance as of December 31, 2012


Windows Division	$	89	$	0	$	0		$	89
Server and Tools		1,144		211		0			1,355
Online Services Division		223		0		0			223
Microsoft Business Division		6,893		979		60			7,932
Entertainment and Devices Division		5,103		27		(2	)		5,128

Total	$	13,452	$	1,217	$	58		$	14,727

The measurement periods for purchase price allocations end as soon as information on the facts and circumstances becomes available, but do not exceed 12 months. Adjustments in purchase price allocations may require a recasting of the amounts allocated to goodwill retroactive to the periods in which the acquisitions 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 business dispositions and 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, 2012							June 30, 2012

Technology-based^(a)	$	3,969	$	(2,165	)	$	1,804	$	3,550	$	(1,899	)	$	1,651
Marketing-related		1,369		(182	)		1,187		1,325		(136	)		1,189
Contract-based		824		(670	)		154		824		(644	)		180
Customer-related		491		(295	)		196		408		(258	)		150

Total	$	6,653	$	(3,312	)	$	3,341	$	6,107	$	(2,937	)	$	3,170

(a)	Technology-based intangible assets included $317 million and $177 million as of December 31, 2012 and June 30, 2012, respectively, of net carrying amount of software to be sold, leased, or otherwise marketed.

Intangible assets amortization expense was $198 million and $376 million for the three and six months ended December 31, 2012, respectively, as compared with $155 million and $264 million for the three and six months ended December 31, 2011, respectively. Amortization of capitalized software was $61 million and $101 million for the three and six months ended December 31, 2012, respectively, and $28 million and $57 million for the three and six months ended December 31, 2011, respectively.

The following table outlines the estimated future amortization expense related to intangible assets held at December 31, 2012:


(In millions)


Year Ending June 30,

2013 (excluding the six months ended December 31, 2012)	$	350
2014		575
2015		491
2016		377
2017		266
Thereafter		1,282

Total	$	3,341

PART I

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NOTE 11 DEBT

As of December 31, 2012, the total carrying value and estimated fair value of our long-term debt, including the current portion, were $14.2 billion and $15.2 billion, respectively. This is compared to a carrying value and estimated fair value of $11.9 billion and $13.2 billion, respectively, as of June 30, 2012. These estimated fair values are based on Level 2 inputs.

The components of our long-term debt, including the current portion, and the associated interest rates were as follows as of December 31, 2012 and June 30, 2012:

Due Date

Face Value

December 31,

2012

Face Value

June 30,

2012

Stated

Interest

Rate

Effective

Interest

Rate

(In millions)

Notes

September 27, 2013

1,000

0.875%

1.000%

June 1, 2014

2,000

2.950%

3.049%

September 25, 2015

1,750

1.625%

1.795%

February 8, 2016

750

2.500%

2.642%

November 15, 2017 ^(a)

600

0.875%

1.084%

June 1, 2019

1,000

4.200%

4.379%

October 1, 2020

1,000

3.000%

3.137%

February 8, 2021

500

4.000%

4.082%

November 15, 2022 ^(a)

750

2.125%

2.239%

June 1, 2039

750

5.200%

5.240%

October 1, 2040

1,000

4.500%

4.567%

February 8, 2041

1,000

5.300%

5.361%

November 15, 2042 ^(a)

900

3.500%

3.571%

Total

13,000

10,750

Convertible Debt

June 15, 2013

1,250

0.000%

1.849%

Total

14,250

12,000

(a)	In November 2012, we issued $2.25 billion of debt securities. The notes are senior unsecured obligations and rank equally with our other unsecured and unsubordinated debt outstanding.

*	Not applicable.

Interest on the notes is paid semi-annually. As of December 31, 2012 and June 30, 2012, the aggregate unamortized discount for our long-term debt, including the current portion, was $62 million and $56 million, respectively.

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. Initially, each $1,000 principal amount of notes was convertible into 29.94 shares of Microsoft common stock at a conversion price of $33.40 per share. The conversion ratio is adjusted periodically for dividends in excess of the initial dividend threshold as defined in the debt agreement. As of December 31, 2012, the net carrying amount of our convertible debt was $1.2 billion and the unamortized discount was $9 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

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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 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 an initial cap price equal to $37.16, which is adjusted periodically to mirror any adjustments to the conversion price. The purchased capped calls were valued at $40 million and recorded to stockholders’ equity.

NOTE 12 INCOME TAXES

Our effective tax rates were approximately 18% and 20% for the three months ended December 31, 2012 and 2011, respectively, and 18% and 20% for the six months ended December 31, 2012 and 2011, respectively. Our effective tax rate was lower than the U.S. federal statutory rate primarily due to 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 have lower income tax rates.

Tax contingencies and other tax liabilities were $7.7 billion and $7.6 billion as of December 31, 2012 and June 30, 2012, 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 those years. In February 2012, the I.R.S. withdrew its 2011 Revenue Agents Report and reopened the audit phase of the examination. As of December 31, 2012, the primary unresolved issue relates to transfer pricing which 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, because we do not believe the remaining open issues will be resolved 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 2011, 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, 2012		June 30, 2012

Volume licensing programs	$	14,708	$	16,717
Other ^(a)		5,105		3,342

Total	$	19,813	$	20,059

(a)

Other includes revenue deferred on: sales of the current version of the Microsoft Office system with a guarantee to be upgraded to the new Office at minimal or no cost (the “Office Upgrade Offer”) and pre-sales of the new Office to original equipment manufacturers (“OEMs”) and retailers before general availability (“Office Pre-Sales”) (collectively, the “Office Deferral”); sales of Windows 7 with an option to upgrade to Windows 8 Pro at a discounted price (the “Windows Upgrade Offer”); and sales of video games with the right to receive specified software upgrades/enhancements (the “Video Game Deferral”).

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Other as of December 31, 2012 includes a net $1.1 billion of unearned revenue associated with the Windows Upgrade Offer, $977 million of unearned revenue associated with the Office Deferral, and $380 million of unearned revenue associated with the Video Game Deferral.

Other as of June 30, 2012 includes $540 million of unearned revenue associated with the Windows Upgrade Offer.

Unearned revenue by segment was as follows:


(In millions)


		December 31, 2012		June 30, 2012

Windows Division	$	2,736	$	2,444
Server and Tools		6,544		7,445
Microsoft Business Division		8,904		9,015
Other segments		1,629		1,155

Total	$	19,813	$	20,059

NOTE 14 COMMITMENTS AND GUARANTEES

Yahoo! Commercial Agreement

On December 4, 2009, we entered into a 10-year agreement with Yahoo! Inc. (“Yahoo!”) whereby Microsoft will provide the exclusive algorithmic and paid search platform for Yahoo! websites. 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 expect the remaining cost of the revenue per search guarantees will be less than $100 million.

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 between 1999 and 2005. We obtained dismissals or reached settlements of all claims made 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 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, 2012, we have recorded a liability related to these claims of approximately $500 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. In April 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 filed an appeal to the Canadian Supreme Court, which was heard in the fall of 2012. The other two actions have been stayed.

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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 Novell’s six claims. 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 as to one claim. Trial of that claim took place from October to December 2011 and resulted in a mistrial because the jury was unable to reach a verdict. In July 2012, the trial court granted Microsoft’s motion for judgment as a matter of law. Novell has appealed this decision to the U.S. Court of Appeals for the Tenth Circuit.

Government Competition Law Matters

In December 2009, the European Commission adopted a decision that rendered legally binding commitments offered by Microsoft to address the Commission’s concerns about the inclusion of Web browsing software in Windows. Among other things, Microsoft committed to display a “Browser Choice Screen” on Windows-based PCs in Europe where Internet Explorer is set as the default browser. Due to a technical error, we failed to deliver the requisite software to enable that display to PCs that came preinstalled with a version of Windows 7 called Windows 7 Service Pack 1. We did deliver the requisite software to PCs running the original version of Windows 7 and earlier editions of Windows. Following notification by the Commission of reports that some PCs were not receiving the update, we promptly fixed the error and advised the Commission of what we had discovered. PCs that come preinstalled with Windows 7 Service Pack 1 are now receiving the Browser Choice Screen software, as intended. In July 2012, the Commission announced that it had opened proceedings to investigate whether Microsoft had failed to comply with this commitment. The Commission stated that if a company is found to have breached a legally binding commitment, the company may be fined up to 10% of its worldwide annual revenue. In October 2012, the Commission issued a Statement of Objections, preliminarily concluding that Microsoft failed to comply with the 2009 commitments. We have provided our written response and waived our right to a hearing.

Patent and Intellectual Property Claims

Motorola Litigation

In October 2010, Microsoft filed patent infringement complaints against Motorola Mobility (“Motorola”) with the International Trade Commission (“ITC”) and in U.S. District Court in Seattle for infringement of nine Microsoft patents by Motorola’s Android devices. Since then, Microsoft and Motorola have filed additional claims against each other in the ITC, in federal district courts in Seattle, Wisconsin, Florida, and California, and in courts in Germany and the United Kingdom. In April 2012, following complaints by Microsoft and Apple, the European Union’s competition office opened two antitrust investigations against Motorola to determine whether it has abused certain of its standard essential patents to distort competition in breach of European Union antitrust rules. In June 2012, we received a request for information from the U.S. Federal Trade Commission (“FTC”) apparently related to an FTC investigation into whether Motorola’s conduct violates U.S. law. The nature of the claims asserted and status of individual matters are summarized below.

International Trade Commission

The hearing in Microsoft’s ITC case against Motorola took place in August 2011 on seven of the nine patents originally asserted in the complaint. In December 2011, the administrative law judge (“ALJ”) issued an initial determination that Motorola infringed one Microsoft patent, and recommended that the ITC issue a limited exclusion order against Motorola prohibiting importation of infringing Motorola Android devices. In May 2012, the ITC issued the limited exclusion order recommended by the ALJ, which became effective on July 18, 2012. Microsoft has appealed certain aspects of the ITC ruling adverse to Microsoft and Motorola has appealed the ITC exclusion order.

In November 2010, Motorola filed an action against Microsoft in the ITC alleging infringement of five Motorola patents by Xbox consoles and accessories and seeking an exclusion order to prohibit importation of the allegedly infringing Xbox products into the U.S. In April 2012, the ALJ found that Xbox products infringe four of the five patents asserted by Motorola. The ALJ recommended that the ITC issue a limited exclusion order and a cease and desist order. Both Microsoft and Motorola sought ITC review of the ALJ’s findings. In June 2012, Microsoft filed a motion to terminate the investigation as to certain patents based on facts arising as the result of Google’s acquisition of Motorola. The

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ITC determined that it would review the ALJ’s initial determination in its entirety and remanded the matter to the ALJ (1) to apply certain ITC case precedent, (2) to rule on Microsoft’s June 2012 motion to terminate, and (3) set a new target date for completion of the investigation. The ALJ held a hearing in December 2012 and has set a target date for a final ITC ruling in July 2013. At Motorola’s request, the ITC has terminated its investigation as to two patents, and in January 2013 Motorola requested that the investigation be terminated as to two additional Motorola patents. If granted, only one Motorola patent will be at issue before the ITC. If the ITC issues an exclusion order or cease and desist order, it will be subject to Presidential review for up to 60 days, during which Microsoft may be able to import Xbox products subject to posting a bond. If an order is issued and survives Presidential review, Microsoft may be able to mitigate the order’s impact by altering Xbox products to avoid Motorola’s infringement claims.

U.S. District Court

The Seattle District Court case filed in October 2010 by Microsoft as a companion to Microsoft’s ITC case against Motorola has been stayed pending the outcome of Microsoft’s ITC case.

In November 2010, Microsoft sued Motorola for breach of contract in U.S. District Court in Seattle, alleging that Motorola breached its commitments to standards-setting organizations to license to Microsoft certain patents on reasonable and non-discriminatory (“RAND”) terms and conditions. Motorola has declared these patents essential to the implementation of the H.264 video standard and the 802.11 Wi-Fi standard. In suits described below, Motorola or a Motorola affiliate subsequently sued Microsoft on those patents in U.S. District Courts, in the ITC, and in Germany. In February 2012, the Seattle District Court granted a partial summary judgment in favor of Microsoft ruling that (1) Motorola entered into binding contractual commitments with standards organizations committing to license its declared-essential patents on RAND terms and conditions; and (2) Microsoft is a third-party beneficiary of those commitments. The court rejected Motorola’s argument that Microsoft had repudiated its right to a RAND license, and ruled a trial is needed to determine whether Motorola is in breach of its obligation to enter into a patent license with Microsoft and, if so, the amount of the RAND royalty. In April 2012, the court issued a temporary restraining order preventing Motorola from taking steps to enforce an injunction in Germany relating to the H.264 video patents. In May 2012, the court converted that order into a preliminary injunction. Motorola appealed the court’s injunction orders to the Court of Appeals for the Ninth Circuit, which affirmed the orders in September 2012. The Seattle District Court held a trial in November 2012 to determine the RAND royalty for Motorola’s H.264 and 802.11 patents. In December 2012, the Seattle District Court ruled that Motorola could not obtain injunctive relief in connection with any of its claims for infringement of its H.264 and 802.11 patents.

Cases filed by Motorola in Wisconsin, California, and Florida, with the exception of one currently stayed case in Wisconsin (a companion case to Motorola’s ITC action), have been transferred to the U.S District Court in Seattle. Motorola and Microsoft both seek damages as well as injunctive relief. No trial dates have been set in any of the transferred cases, and the court has stayed these cases on agreement of the parties.

•

In the transferred cases, Motorola asserts 15 patents are infringed by many Microsoft products including Windows Mobile 6.5 and Windows Phone 7, Windows Marketplace, Silverlight, Windows Vista and Windows 7, Exchange Server 2003 and later, Exchange ActiveSync, Windows Live Messenger, Lync Server 2010, Outlook 2010, Office 365, SQL Server, Internet Explorer 9, Xbox, and Kinect.

•

In the Motorola action originally filed in California, Motorola asserts that Microsoft violated antitrust laws in connection with Microsoft’s assertion of patents against Motorola that Microsoft has agreed to license to certain qualifying entities on RAND terms and conditions.

•

In counterclaims in the patent actions brought by Motorola, Microsoft asserts 14 patents are infringed by Motorola Android devices and certain Motorola digital video recorders.

Germany

In July 2011, Motorola filed patent infringement actions in Germany against Microsoft and several Microsoft subsidiaries.

•

Two of the patents are asserted by Motorola to be essential to implementation of the H.264 video standard, and Motorola alleges that H.264 capable products including Xbox 360, Windows 7, Media Player, and Internet Explorer infringe those patents. Motorola seeks damages and an injunction. In May 2012, the court issued an injunction relating to all H.264 capable Microsoft products in Germany. However, due to orders in the separate litigation pending in Seattle, Washington described above, Motorola is enjoined from taking steps to enforce the German injunction. Damages would be determined in later proceedings. Microsoft has appealed the rulings of the first instance court.

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•

Motorola asserts one of the patents covers certain syncing functionality in the ActiveSync protocol employed by Windows Phone 7, Outlook Mobile, Hotmail Mobile, Exchange Online, Exchange Server, and Hotmail Server. Motorola seeks damages and an injunction. If the court rules in favor of Motorola, an injunction could be issued immediately relating to these products employing the ActiveSync protocol in Germany, which Motorola could then take steps to enforce. We expect the court to issue a ruling in February 2013. If Motorola prevails, damages would be determined in later proceedings.

•

Should injunction orders be issued and enforced by Motorola, Microsoft may be able to mitigate the adverse impact by altering its products to avoid Motorola’s infringement claims.

In lawsuits Microsoft filed in Germany in September, October, and December 2011 and in April 2012, Microsoft asserts Motorola Android devices infringe Microsoft patents. Microsoft seeks damages and an injunction. In May, July, and September 2012, courts in Germany issued injunctions on three patents against Motorola Android devices and in May and July ruled against Microsoft on two patents. Microsoft is taking steps to enforce the injunctions. Damages will be determined in later proceedings. Each party has appealed or is expected to appeal the rulings against it.

United Kingdom

In December 2011, Microsoft filed an action against Motorola in the High Court of Justice, Chancery Division, Patents Court, in London, England, seeking to revoke the UK part of the European patent asserted by Motorola in Germany against the ActiveSync protocol. In February 2012, Motorola counterclaimed alleging infringement of the patent and seeking damages and an injunction. A trial took place in December 2012, and the court ruled that Motorola’s patent is invalid and revoked. The court also ruled that the patent, even if valid, would be licensed under the grant-back clause in Google’s ActiveSync license.

Other Patent and Intellectual Property Claims

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, 2012, we had accrued aggregate liabilities of $531 million in other current liabilities and $194 million in other long-term liabilities for all of our contingent legal matters. While we intend to defend these matters vigorously, adverse outcomes that we estimate could reach approximately $1.8 billion 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.

NOTE 16 STOCKHOLDERS’ EQUITY

Share Repurchases

We repurchased the following shares of common stock through our repurchase program, during the periods presented:


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


	2012		2011		2012		2011

Shares of common stock repurchased		58		39		91		78
Value of common stock repurchased	$	1,607	$	1,000	$	2,607	$	2,000

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Excluded from this table are shares repurchased to settle statutory employee tax withholding related to the vesting of stock awards. We repurchased all shares with cash resources. As of December 31, 2012, approximately $5.6 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 2013

September 18, 2012

0.23

November 15, 2012

1,933

December 13, 2012

November 28, 2012

0.23

February 21, 2013

1,926

March 14, 2013

Fiscal Year 2012

September 20, 2011

0.20

November 17, 2011

1,683

December 8, 2011

December 14, 2011

0.20

February 16, 2012

1,683

March 8, 2012

The estimate of the amount to be paid as a result of the November 28, 2012 declaration was included in other current liabilities as of December 31, 2012.

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 Division, Server and Tools, Online Services Division, Microsoft Business Division, and Entertainment and Devices Division. During the three months ended December 31, 2012, we changed the name of our Windows & Windows Live Division to Windows 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.

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, reflecting immaterial movements of business activities between segments and changes in cost allocations.

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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,


	2012			2011			2012			2011

Revenue
Windows Division	$	5,253		$	4,714		$	9,654		$	9,552
Server and Tools		5,191			4,740			9,746			8,957
Online Services Division		893			798			1,606			1,456
Microsoft Business Division		6,491			6,296			12,174			11,914
Entertainment and Devices Division		4,149			4,238			6,088			6,207
Unallocated and other		(521	)		99			(1,804	)		171

Consolidated	$	21,456		$	20,885		$	37,464		$	38,257

Operating income (loss)
Windows Division	$	2,671		$	2,854		$	5,484		$	6,100
Server and Tools		2,129			1,956			3,872			3,516
Online Services Division		(283	)		(456	)		(642	)		(969	)
Microsoft Business Division		4,367			4,172			8,198			7,875
Entertainment and Devices Division		937			520			954			874
Reconciling amounts		(2,050	)		(1,052	)		(4,787	)		(2,199	)

Consolidated	$	7,771		$	7,994		$	13,079		$	15,197

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,


	2012			2011			2012			2011

Corporate-level activity ^(a)	$	(1,524	)	$	(1,082	)	$	(2,915	)	$	(2,260	)
Revenue reconciling amounts ^(b)		(578	)		24			(1,927	)		52
Other		52			6			55			9

Total	$	(2,050	)	$	(1,052	)	$	(4,787	)	$	(2,199	)

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

(b)

Revenue reconciling amounts for the three months ended December 31, 2012 includes: the recognition of $783 million of previously deferred revenue related to pre-sales of Windows 8 to OEMs and retailers before general availability (“Windows 8 Pre-Sales”); a net $161 million of revenue deferred related to the Windows Upgrade Offer; a net $788 million of revenue deferred related to the Office Deferral; and $380 million of revenue deferred related to the Video Game Deferral.

Revenue reconciling amounts for the six months ended December 31, 2012 includes: a net $545 million of revenue deferred related to the Windows Upgrade Offer; $977 million of revenue deferred related to the Office Deferral; and $380 million of revenue deferred related to the Video Game Deferral.

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.

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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, 2012, and the related consolidated statements of income, comprehensive income, cash flows, and stockholders’ equity for the three-month and six-month periods ended December 31, 2012 and 2011. 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, 2012, 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 26, 2012 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, 2012 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 24, 2013

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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, 2012 and our financial statements and accompanying Notes to Financial Statements in this Form 10-Q.

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, by offering an array of services, including cloud-based services to consumers and businesses, by designing and selling hardware that integrates with our cloud-based services, and by delivering relevant online advertising to a global 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 that can further transform the industry and our business. At Microsoft, we push the boundaries of what is possible through a broad range of research and development activities that seek to anticipate the changing demands of customers, industry trends, and competitive forces.

Key Opportunities and Investments

We invest research and development resources in new products and services in the areas where we see significant opportunities to drive future growth. As we look forward, the capabilities and accessibility of PCs, tablets, phones, televisions, and other devices powered by rich software platforms and applications continue to grow. With this trend, we believe the full potential of software will be seen and felt in how people use these devices and the associated services at work and in their personal lives.

Devices with End-User Services

We work with an ecosystem of partners to deliver a broad spectrum of Windows devices. In some cases, we build our own devices, as we have chosen to do with Xbox and Surface. In all our work with partners and on our own devices, we focus on delivering seamless services and experiences across devices. As consumer services and hardware advance, we expect they will continue to better complement one another, connecting the devices people use daily to unique communications, productivity, and entertainment services from Microsoft and our partners and developers around the world.

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Windows 8 reflects this shift. Launched in October 2012 on a variety of state-of-the-art hardware, Windows 8 is built to take advantage of our consumer cloud services. Windows 8 is made for both personal and professional use and unites the light, thin, and convenient aspects of a tablet with the power of a PC. For example, Xbox Music, Video, Games, and SmartGlass applications make it possible to select and experience entertainment across a range of devices by simplifying and increasing the accessibility of those experiences. SkyDrive, our cloud storage solution, connects content across all of a user’s devices. Bing’s search technologies in Windows 8 are designed to help users get more done. Skype has a new Windows 8 application and connects directly to the new Office.

The new Office is designed for Windows 8 and takes advantage of new mobile form factors with touch and pen capabilities. It unlocks new experiences for reading, note taking, meetings, and communications and brings social experiences directly into productivity and collaboration scenarios. The combination of a Windows 8 tablet with OneNote and SkyDrive will transform how to take notes, annotate documents, and share information.

Services for the Enterprise

Today, businesses face important opportunities and challenges. Enterprise IT departments are asked to deploy technology that drives business strategy forward. They decide what solutions will make employees more productive, collaborative, and satisfied. They work to unlock business insights from a world of data. At the same time, they must manage and secure corporate information that employees access across a growing number of personal and corporate devices.

To address these opportunities, businesses look to our world-class business applications like Microsoft Dynamics, Office, Exchange, SharePoint, Lync, and our business intelligence solutions. They rely on our technology to manage employee corporate identity and to protect their corporate data. And, increasingly, businesses of all sizes are looking to Microsoft to realize the benefits of the cloud.

Helping businesses move to the cloud is one of our largest opportunities. Cloud-based solutions provide customers with software, services, and content over the Internet by way of shared computing resources located in centralized data centers. 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 improving the utilization of computing, storage, and network resources; and multi-tenancy lowers application maintenance labor costs for large public clouds. Because of the improved economics, the cloud offers unique levels of elasticity and agility that enable new solutions and applications. For businesses of all sizes, the cloud creates the opportunity to focus on innovation while leaving non-differentiating activities to reliable and cost-effective providers.

Unique to Microsoft, we continue to design and deliver cloud solutions that allow our customers to use both the cloud and their on-premise assets however best suits their own needs. For example, a company can choose to deploy Office or Microsoft Dynamics on premises, as a cloud service, or a combination of both. With Windows Server 2012, Windows Azure, and System Center infrastructure, businesses can deploy applications in their own datacenter, a partner’s datacenter, or in Microsoft’s datacenter with common security, management, and administration across all environments, with the flexibility and scale they desire. Our business customers tell us these hybrid capabilities are critical to harnessing the power of the cloud so they can reach new levels of efficiency and tap new areas of growth.

Our Future Opportunity

There are several distinct areas of technology that we are focused on driving forward. Our goal is to lead the industry in these areas over the long term, which we expect will translate to sustained growth well into the future. We are investing significant resources in:

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Developing new form factors that have increasingly natural ways to use them, including touch, gestures, and speech.

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Making technology more intuitive and able to act on our behalf, instead of at our command, with machine learning.

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Building and running cloud services in ways that unleash new experiences and opportunities for businesses and individuals.

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Firmly establishing our Windows platform across the PC, tablet, phone, server, and cloud to drive a thriving ecosystem of developers, unify the cross-device user experience, and increase agility when bringing new advances to market.

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Delivering new scenarios with improvements in how people learn, work, play, and interact with one another.

We believe the breadth of our devices and services portfolio, our large, global partner and customer base, and the growing Windows ecosystem position us to be a leader in these areas.

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 may be developed 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 hire 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.

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.

Unearned Revenue

Quarterly and annual revenue may be impacted by the deferral of revenue. See the discussions below regarding revenue deferred on: sales of Windows 7 with an option to upgrade to Windows 8 Pro at a discounted price (the “Windows Upgrade Offer”) and pre-sales of Windows 8 to original equipment manufacturers (“OEMs”) and retailers before general availability (“Windows 8 Pre-Sales”) (collectively, the “Windows Deferral”); sales of the current version of the Microsoft Office system with a guarantee to be upgraded to the new Office at minimal or no cost (the “Office Upgrade Offer”) and pre-sales of the new Office to OEMs and retailers before general availability (“Office Pre-Sales”) (collectively, the “Office Deferral”); and on sales of video games with the right to receive specified software upgrades/enhancements (the “Video Game 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


	2012		2011				2012		2011

Revenue	$	21,456	$	20,885		3%	$	37,464	$	38,257		(2)%
Operating income	$	7,771	$	7,994		(3)%	$	13,079	$	15,197		(14)%
Diluted earnings per share	$	0.76	$	0.78		(3)%	$	1.28	$	1.46		(12)%

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Three months ended December 31, 2012 compared with three months ended December 31, 2011

Revenue increased, primarily due to the launch of Windows 8 and Surface on October 26, 2012, and strong sales of Server and Tools products and services, offset in part by lower Entertainment and Devices revenue. During the three months ended December 31, 2012, we recognized a net $622 million of revenue related to the Windows Deferral, and we deferred a net $788 million of revenue related to the Office Deferral and $380 million of revenue related to the Video Game Deferral.

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

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Sales and marketing expenses increased $547 million or 15%, primarily reflecting advertising of Windows 8 and Surface.

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Research and development expenses increased $157 million or 7%, due mainly to higher headcount-related expenses, primarily related to the Entertainment and Devices Division.

Six months ended December 31, 2012 compared with six months ended December 31, 2011

Revenue decreased, primarily due to the deferral of certain Office, Windows, and video game revenue and lower Entertainment and Devices revenue, offset in part by strong sales of Server and Tools products and services and the launch of Windows 8 and Surface. During the six months ended December 31, 2012, we deferred $977 million of revenue related to the Office Deferral, a net $545 million of revenue related to the Windows Deferral, and $380 million of revenue related to the Video Game Deferral.

Operating income decreased, reflecting lower revenue and increased cost of revenue and operating expenses. Key changes in cost of revenue and operating expenses were:

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Sales and marketing expenses increased $592 million or 9%, primarily reflecting advertising of Windows 8 and Surface.

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Cost of revenue increased $445 million or 5%, reflecting payments made to Nokia related to joint strategic initiatives, higher headcount-related expenses, primarily related to Server and Tools, and increased product costs associated with Surface, offset in part by lower volumes of Xbox 360 consoles sold.

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Research and development expenses increased $288 million or 6%, due mainly to higher headcount-related expenses, primarily related to the Entertainment and Devices Division.

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.

Windows Division


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


	2012		2011				2012		2011

Revenue	$	5,881	$	4,741		24%	$	9,125	$	9,615		(5)%
Operating income	$	3,296	$	2,880		14%	$	4,950	$	6,161		(20)%

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 seamless operations across the user’s hardware and software. Windows Division offerings consist of the Windows operating system, software, and services, Surface, and Microsoft PC hardware products. The general availability of Surface, Windows 8, and Windows 8 and Windows RT devices started on October 26, 2012.

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Excluding the impact of the Windows Deferral, approximately 65% of total Windows Division revenue comes from Windows operating system software purchased by OEMs, which they pre-install on equipment they sell. The remaining Windows Division revenue is generated by commercial and retail sales of Windows, Surface, PC hardware products, and online advertising.

Three months ended December 31, 2012 compared with three months ended December 31, 2011

Windows Division revenue increased from the prior year, due in part to the recognition of a net $622 million of revenue related to Windows Deferral, as well as due to sales of Surface and Windows 8 upgrades. OEM revenue grew 17%, reflecting the net Windows Deferral recognition and increased demand in our distribution channels, offset in part by a decline in the x86 PC market.

Windows Division operating income increased, primarily due to revenue growth, offset in part by higher sales and marketing expenses and cost of revenue. Sales and marketing expenses increased $420 million or 49%, reflecting advertising costs associated with the launch of Windows 8 and Surface. Cost of revenue increased $293 million or 58%, including product costs associated with Surface and Windows 8 and Windows 8 upgrade support costs.

Six months ended December 31, 2012 compared with six months ended December 31, 2011

Windows Division revenue decreased from the prior year, due in part to the deferral of a net $545 million of revenue related to the Windows Upgrade Offer, as well as due to a decline in the x86 PC market and continued higher relative growth in emerging markets, where average selling prices are lower than developed markets. The revenue decrease was offset in part by sales of Surface and Windows 8 upgrades.

Windows Division operating income decreased, due mainly to lower revenue and higher sales and marketing expenses and cost of revenue. Sales and marketing expenses increased $368 million or 24%, reflecting advertising costs associated with the launch of Windows 8 and Surface. Cost of revenue increased $292 million or 30%, including product costs associated with Surface and Windows 8 and Windows 8 upgrade support costs.

Server and Tools


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


	2012		2011				2012		2011

Revenue	$	5,186	$	4,737		9%	$	9,739	$	8,953		9%
Operating income	$	2,121	$	1,950		9%	$	3,858	$	3,503		10%

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 80% of Server and Tools revenue comes from product revenue, including purchases through volume licensing programs, licenses sold to OEMs, and retail packaged product, while the remainder comes from Enterprise Services.

Three months ended December 31, 2012 compared with three months ended December 31, 2011

Server and Tools revenue increased in both product sales and Enterprise Services. Product revenue increased $347 million or 9%, driven primarily by growth in SQL Server, Windows Server, and System Center, reflecting continued adoption of the Windows platform. Enterprise Services revenue grew $102 million or 10%, due to growth in both Premier product support and consulting services.

Server and Tools operating income increased, primarily due to revenue growth, offset in part by higher cost of revenue and sales and marketing expenses. Cost of revenue increased $163 million or 17%, primarily reflecting higher headcount-related expenses. Sales and marketing expenses grew $76 million or 7%, reflecting increased fees paid to third-party enterprise software advisors and corporate sales and marketing activities.

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Six months ended December 31, 2012 compared with six months ended December 31, 2011

Server and Tools revenue increased in both product sales and Enterprise Services. Product revenue increased $560 million or 8%, driven primarily by growth in SQL Server, System Center, and Windows Server, reflecting continued adoption of the Windows platform. Enterprise Services revenue grew $226 million or 12%, due to growth in both Premier product support and consulting services.

Server and Tools operating income increased, primarily due to revenue growth, offset in part by higher cost of revenue and sales and marketing expenses. Cost of revenue increased $273 million or 15%, primarily reflecting higher headcount-related expenses. Sales and marketing expenses grew $124 million or 6%, reflecting increased fees paid to third-party enterprise software advisors and corporate sales and marketing activities.

Online Services Division


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


	2012			2011					2012			2011

Revenue	$	869		$	784			11%	$	1,566		$	1,425			10%
Operating loss	$	(283	)	$	(459	)		38%	$	(647	)	$	(973	)		34%

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

Three months ended December 31, 2012 compared with three months ended December 31, 2011

Online advertising revenue grew $109 million or 15% to $823 million, reflecting continued growth in search advertising revenue, offset in part by decreased display advertising revenue. Search revenue grew, primarily due to increased revenue per search. According to third-party sources, Bing organic U.S. market share for the month of December 2012 was approximately 16%, and grew 120 basis points year over year. Bing-powered U.S. market share, including Yahoo! properties, was approximately 26% for the month of December 2012, down 90 basis points year over year.

OSD’s operating loss was reduced by higher revenue and lower cost of revenue and sales and marketing expenses. Cost of revenue decreased $72 million, driven by lower traffic acquisition costs and Yahoo! reimbursement costs. Sales and marketing expenses decreased $31 million or 16%, due mainly to decreased advertising and corporate marketing activities.

Six months ended December 31, 2012 compared with six months ended December 31, 2011

Online advertising revenue grew $193 million or 15% to $1.5 billion, reflecting continued growth in search advertising revenue, offset in part by decreased display advertising revenue. Search revenue grew, primarily due to increased revenue per search.

OSD’s operating loss was reduced by higher revenue and lower cost of revenue and sales and marketing expenses, offset in part by higher research and development expenses. Cost of revenue decreased $163 million, driven by lower traffic acquisition costs and Yahoo! reimbursement costs. Sales and marketing expenses decreased $71 million or 19%, due mainly to decreased advertising and corporate marketing activities. Research and development expenses increased $47 million or 8%, primarily reflecting higher headcount-related expenses.

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Microsoft Business Division


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


	2012		2011				2012		2011

Revenue	$	5,691	$	6,310		(10)%	$	11,192	$	11,945		(6)%
Operating income	$	3,565	$	4,188		(15)%	$	7,214	$	7,906		(9)%

Microsoft Business Division (“MBD”) develops and markets software and online services designed to increase personal, team, and organization productivity. MBD offerings include the Microsoft Office system (comprising mainly Office, SharePoint, Exchange, Lync, and Office 365), which generates over 90% of MBD revenue, and Microsoft Dynamics business solutions. We evaluate MBD results based upon the nature of the end user in two primary parts: business revenue, which includes Microsoft Office system revenue generated through volume licensing agreements and Microsoft Dynamics revenue; and consumer revenue, which includes revenue from retail packaged product sales and OEM revenue.

Three months ended December 31, 2012 compared with three months ended December 31, 2011

MBD revenue decreased, due mainly to the deferral of $689 million of revenue related to the Office Upgrade Offer and $99 million of revenue related to Office Pre-Sales. This decrease was offset in part by overall increased sales of the Microsoft Office system. Business revenue increased $196 million or 4%, primarily reflecting growth in multi-year volume licensing revenue and a 12% increase in Microsoft Dynamics revenue. Consumer revenue decreased $815 million or 67%, driven primarily by the Office Deferral.

MBD revenue for the three months ended December 31, 2012 included an unfavorable foreign currency impact of $103 million.

MBD operating income decreased, mainly due to lower revenue.

Six months ended December 31, 2012 compared with six months ended December 31, 2011

MBD revenue decreased, due mainly to the deferral of $876 million of revenue related to the Office Upgrade Offer and $101 million of revenue related to Office Pre-Sales. This decrease was offset in part by overall increased sales of the Microsoft Office system. Business revenue increased $339 million or 4%, primarily reflecting growth in multi-year volume licensing revenue and an 11% increase in Microsoft Dynamics revenue. Consumer revenue decreased $1.1 billion or 47%, driven by the Office Deferral and a decline in the x86 PC market.

MBD revenue for the six months ended December 31, 2012 included an unfavorable foreign currency impact of $222 million.

MBD operating income decreased, mainly due to lower revenue, offset in part by lower research and development expenses. Research and development expenses decreased $78 million or 8%, primarily due to the capitalization of certain Microsoft Office system software development costs, offset in part by increased headcount-related expenses.

Entertainment and Devices Division


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


	2012		2011				2012		2011

Revenue	$	3,772	$	4,238		(11)%	$	5,719	$	6,200		(8)%
Operating income	$	596	$	517		15%	$	619	$	860		(28)%

Entertainment and Devices Division (“EDD”) develops and markets products and services designed to entertain and connect people. EDD offerings include the Xbox 360 entertainment platform (which includes the Xbox 360 gaming and entertainment console, Kinect for Xbox 360, Xbox 360 video games, Xbox LIVE, and Xbox 360 accessories), Mediaroom (our Internet protocol television software), Skype, and Windows Phone, including related patent licensing revenue. We acquired Skype on October 13, 2011, and its results of operations from that date are reflected in our results discussed below.

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Three months ended December 31, 2012 compared with three months ended December 31, 2011

EDD revenue decreased, primarily due to lower Xbox 360 platform revenue, offset in part by higher Windows Phone revenue. Xbox 360 platform revenue decreased $1.1 billion or 29%, due mainly to lower volumes of consoles sold and lower video game revenue, offset in part by higher Xbox LIVE revenue. We shipped 5.9 million Xbox 360 consoles during the second quarter of fiscal year 2013, compared with 8.2 million Xbox 360 consoles during the second quarter of fiscal year 2012. Video game revenue decreased, primarily due to $380 million of revenue deferred associated with the Video Game Deferral. Windows Phone revenue increased $546 million, including patent licensing revenue and increased sales of Windows Phone licenses.

EDD operating income increased, due mainly to lower cost of revenue and sales and marketing expenses, offset in part by decreased revenue and increased research and development expenses. Cost of revenue decreased $544 million or 19%, mainly due to decreased sales of Xbox 360 consoles, offset in part by payments made to Nokia related to joint strategic initiatives and increased royalties on Xbox LIVE content and video games. Sales and marketing expenses decreased $92 million or 21%, primarily reflecting decreased Xbox 360 platform marketing. Research and development expenses increased $98 million or 25%, primarily reflecting higher headcount-related expenses.

Six months ended December 31, 2012 compared with six months ended December 31, 2011

EDD revenue decreased, primarily due to lower Xbox 360 platform revenue, offset in part by higher Windows Phone revenue. Xbox 360 platform revenue decreased $1.5 billion or 27%, due mainly to lower volumes of consoles sold and lower video game revenue, offset in part by higher Xbox LIVE revenue. We shipped 7.5 million Xbox 360 consoles during the first half of fiscal year 2013, compared with 10.5 million Xbox 360 consoles during the first half of fiscal year 2012. Video game revenue decreased, primarily due to $380 million of revenue deferred associated with the Video Game Deferral. Windows Phone revenue increased $690 million, including patent licensing revenue and higher sales of Windows Phone licenses.

EDD operating income decreased, due mainly to lower revenue and higher research and development expenses, offset in part by lower cost of revenue and sales and marketing expenses. Research and development expenses increased $235 million or 33%, primarily reflecting higher headcount-related expenses. Cost of revenue decreased $392 million or 10%, mainly due to lower sales of Xbox 360 consoles, offset in part by payments made to Nokia related to joint strategic initiatives. Sales and marketing expenses decreased $90 million or 14%, primarily reflecting decreased Xbox 360 platform marketing.

Corporate-Level Activity


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


	2012			2011					2012			2011

Corporate-level activity	$	(1,524	)	$	(1,082	)		(41)%	$	(2,915	)	$	(2,260	)		(29)%

Certain 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; costs of operating our retail stores; and legal settlements and contingencies.

Corporate-level expenses increased, due mainly to increased retail stores expenses, other increased headcount-related expenses, and higher intellectual property licensing costs.

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COST OF REVENUE

Cost of Revenue

(In millions, except percentages)

Three Months Ended
December 31,

Percentage

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