Notes to Financial Statements

Accounting Policies

Principles of consolidation
The financial statements include the accounts of Microsoft and its subsidiaries. Significant intercompany transactions and balances have been eliminated. Investments in 50% owned joint ventures are accounted for using the equity method; the Company’s share of joint ventures’ activities is reflected in other expenses.

Estimates and assumptions
Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples include provisions for returns and bad debts and the length of product life cycles and buildings’ lives. Actual results may differ from these estimates.

Foreign currencies
Assets and liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Translation adjustments resulting from this process are charged or credited to equity. Revenue, costs, and expenses are translated at average rates of exchange prevailing during the year. Gains and losses on foreign currency transactions are included in other expenses.

Revenue recognition
Revenue is recognized when earned. The Company’s revenue recognition policies are in compliance with American Institute of Certified Public Accountants Statements of Position 97-2 and 98-4, Software Revenue Recognition. Revenue from products licensed to original equipment manufacturers is recorded when OEMs ship licensed products while revenue from organization license programs is recorded when the software has been delivered and the customer is invoiced. Revenue from packaged product sales to distributors and resellers is recorded when related products are shipped. Maintenance and subscription revenue is recognized ratably over the contract period. Revenue attributable to significant support (technical support and unspecified enhancements such as service packs and Internet browser updates) is based on the price charged or derived value of the undelivered elements and is recognized ratably on a straight-line basis over the product’s life cycle. Costs related to insignificant obligations, which include telephone support for certain products, are accrued. Provisions are recorded for returns and bad debts.

Research and development
Research and development costs are expensed as incurred. Statement of Financial Accounting Standards (SFAS) 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed, does not materially affect the Company.

Telephone support
Telephone support costs are included in sales and marketing.

Income taxes
Income tax expense includes U.S. and international income taxes, plus an accrual for U.S. taxes on undistributed earnings of international subsidiaries. Certain items of income and expense are not reported in tax returns and financial statements in the same year. The tax effect of this difference is reported as deferred income taxes. Tax credits are accounted for as a reduction of tax expense in the year in which the credits reduce taxes payable.

Stock split
In February 1998, outstanding shares of common stock were split two-for-one. All share and per share amounts have been restated.

Financial instruments
The Company considers all liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. Short-term investments generally mature between three months and five years from the purchase date. All cash and short-term investments are classified as available for sale and are recorded at market. Cost approximates market for all classifications of cash and short-term investments; realized and unrealized gains and losses were not material.

Publicly tradeable equity securities are recorded at market; unrealized gains and losses are reflected in stockholders’ equity. The pretax unrealized gain was $1.4 billion at June 30, 1998.

Property and equipment
Property and equipment is stated at cost and depreciated using the straight-line method over the shorter of the estimated life of the asset or the lease term, ranging from one to 30 years.

Reclassifications
Certain reclassifications have been made for consistent presentation.

Unearned Revenue

Microsoft believes that Internet technologies are integral to its products and has committed to integrating these technologies, such as its browser software, Microsoft Internet Explorer, into existing products at no additional cost to its customers. Given this strategy and other commitments such as telephone support, Internet-based technical support, and unspecified product enhancements, Microsoft recognizes approximately 20% of Windows operating systems OEM revenue and approximately 35% of retail versions revenue over the product life cycles, currently estimated at two years. The unearned portion of revenue from Windows operating systems was $860 million and $1.19 billion at June 30, 1997 and 1998.

Since Office 97 is also tightly integrated with the Internet, and in the view of subsequent delivery of new Internet technologies, enhancements, and other support, a ratable revenue recognition policy was implemented for Office 97. Approximately 20% of Office 97 revenue is recognized ratably over the estimated 18-month product life cycle. Unearned revenue associated with Office 97 totaled $300 million and $770 million at June 30, 1997 and 1998.

Unearned revenue also includes maintenance and other subscription contracts, including organization license agreements.

Financial Risks

The Company’s investment portfolio is diversified and consists primarily of short-term investment grade securities. Interest rate fluctuations impact the carrying value of the portfolio. While no hedge was in place on June 30, 1998, the Company routinely hedges the portfolio in case of a catastrophic increase in interest rates. At June 30, 1997 and 1998, approximately 31% and 40% of accounts receivable represented amounts due from ten customers. One customer accounted for approximately 13%, 12%, and 8% of revenue in 1996, 1997, and 1998.

Finished goods sales to international customers in Europe, Japan, and Australia are primarily billed in local currencies. Payment cycles are relatively short, generally less than 90 days. European manufacturing costs and international selling, distribution, and support costs are generally disbursed in local currencies. Local currency cash balances in excess of short-term operating needs are generally converted into U.S. dollar cash and short-term investments on receipt. Therefore, foreign exchange rate fluctuations generally do not create a risk of material balance sheet gains or losses. As a result, Microsoft’s hedging activities for balance sheet exposures have been minimal.

Foreign exchange rates affect the translated results of operations of the Company’s foreign subsidiaries. The Company hedges a percentage of planned international revenue with purchased options. The notional amount of the options outstanding at June 30, 1998 was $2.1 billion. At June 30, 1998, the fair value and premiums paid for the options were not material.

Cash and Short-Term Investments

In millions

Property and Equipment

In millions

During 1997 and 1998, depreciation expense, of which the majority related to computer equipment, was $353 million and $528 million; disposals were immaterial.

Income Taxes

The provision for income taxes consisted of:

In millions

U.S. and international components of income before income taxes were:

In millions

The effective income tax rate was 35.0% in 1996 and 1997. The effective tax rate increased to 36.9% in 1998 due to the nondeductible write-off of WebTV in-process technologies.

Income taxes payable were:

In millions

Income taxes have been settled with the Internal Revenue Service (IRS) for all years through 1989. The IRS has assessed taxes for 1990 and 1991 which the Company is contesting in Tax Court. The IRS is examining the Company’s U.S. income tax returns for 1992 through 1994. Management believes any related adjustments that might be required will not be material to the financial statements. Income taxes paid were $758 million in 1996, $1.1 billion in 1997, and $1.1 billion in 1998.
 

Last updated May 27, 2010

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