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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

 

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

 

For the Quarterly Period Ended September 30, 2020

 

OR

 

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 001-37845

 

MICROSOFT CORPORATION

 

 

Washington

 

91-1144442

(State of incorporation)

 

(I.R.S. ID)

 

ONE MICROSOFT WAY, REDMOND, washington 98052-6399

(425) 882-8080

www.microsoft.com/investor

 

 

 

 

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

 

 

 

 

 

 

 

Title of each class

 

Trading Symbol

 

Name of exchange on which registered

 

 

 

 

 

Common stock, $0.00000625 par value per share

 

MSFT

 

NASDAQ

2.125% Notes due 2021

 

MSFT

 

NASDAQ

3.125% Notes due 2028

 

MSFT

 

NASDAQ

2.625% Notes due 2033

 

MSFT

 

NASDAQ

 

 

 

 

 

Securities registered pursuant to Section 12(g) of the Act:

 

 

 

 

 

 

 

 

 

NONE

 

 

 

 

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      No  

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files).    Yes      No  

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

 

Large Accelerated Filer 

 

Accelerated Filer 

Non-accelerated Filer 

 

Smaller Reporting Company 

 

 

Emerging Growth Company 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  

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

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

 

Class

 

Outstanding as of October 22, 2020

 

 

 

 

 

Common Stock, $0.00000625 par value per share

 

 

7,560,495,969 shares

 

 

 

 

 

 


 

MICROSOFT CORPORATION

FORM 10-Q

For the Quarter Ended September 30, 2020

INDEX

 

 

 

Page

PART I.

FINANCIAL INFORMATION

 

 

 

 

 

 

Item 1.

Financial Statements

 

 

 

 

 

 

 

 

a)

Income Statements for the Three Months Ended September 30, 2020 and 2019

3

 

 

 

 

 

 

 

b)

Comprehensive Income Statements for the Three Months Ended September 30, 2020 and 2019

4

 

 

 

 

 

 

 

c)

Balance Sheets as of September 30, 2020 and June 30, 2020

5

 

 

 

 

 

 

 

d)

Cash Flows Statements for the Three Months Ended September 30, 2020 and 2019

6

 

 

 

 

 

 

 

e)

Stockholders’ Equity Statements for the Three Months Ended September 30, 2020 and 2019

7

 

 

 

 

 

 

 

f)

Notes to Financial Statements

8

 

 

 

 

 

 

 

g)

Report of Independent Registered Public Accounting Firm

28

 

 

 

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

29

 

 

 

 

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

42

 

 

 

 

 

 

Item 4.

Controls and Procedures

42

 

 

 

 

 

PART II. 

OTHER INFORMATION

 

 

 

 

 

 

 

Item 1.

Legal Proceedings

43

 

 

 

 

 

 

Item 1A.

Risk Factors

43

 

 

 

 

 

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

56

 

 

 

 

 

 

Item 6.

Exhibits

57

 

 

 

 

 

SIGNATURE

58

 

 

 

2


PART I

Item 1

 

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

INCOME STATEMENTS

 

(In millions, except per share amounts) (Unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

2020

 

 

2019

 

 

 

 

 

Revenue:

 

 

 

 

 

 

 

 

Product

 

$

15,803

 

 

$

15,768

 

Service and other

 

 

21,351

 

 

 

17,287

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total revenue

 

 

37,154

 

 

 

33,055

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of revenue:

 

 

 

 

 

 

 

 

Product

 

 

3,597

 

 

 

3,305

 

Service and other

 

 

7,405

 

 

 

7,101

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total cost of revenue

 

 

11,002

 

 

 

10,406

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross margin

 

 

26,152

 

 

 

22,649

 

Research and development

 

 

4,926

 

 

 

4,565

 

Sales and marketing

 

 

4,231

 

 

 

4,337

 

General and administrative

 

 

1,119

 

 

 

1,061

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating income

 

 

15,876

 

 

 

12,686

 

Other income, net

 

 

248

 

 

 

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income before income taxes

 

 

16,124

 

 

 

12,686

 

Provision for income taxes

 

 

2,231

 

 

 

2,008

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

13,893

 

 

$

10,678

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings per share:

 

 

 

 

 

 

 

 

Basic

 

$

1.84

 

 

$

1.40

 

Diluted

 

$

1.82

 

 

$

1.38

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding:

 

 

 

 

 

 

 

 

Basic

 

 

7,566

 

 

 

7,634

 

Diluted

 

 

7,637

 

 

 

7,710

 

 

 

 

 

 

 

 

 

 

 

Refer to accompanying notes.

3


PART I

Item 1

 

COMPREHENSIVE INCOME STATEMENTS

 

(In millions) (Unaudited)

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

2020

 

 

2019

 

 

 

 

 

Net income

 

$

13,893

 

 

$

10,678

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss), net of tax:

 

 

 

 

 

 

 

 

Net change related to derivatives

 

 

4

 

 

 

(2

)

Net change related to investments

 

 

(201

)

 

 

577

 

Translation adjustments and other

 

 

111

 

 

 

(296

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss)

 

 

(86

)

 

 

279

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income

 

$

13,807

 

 

$

10,957

 

 

 

 

 

 

 

 

 

 

 

 

Refer to accompanying notes.

4


PART I

Item 1

 

BALANCE SHEETS

 

(In millions) (Unaudited)

 

 

 

 

 

 

 

 

 

 

September 30,
2020

 

 

June 30,
2020

 

 

 

 

 

 

 

 

 

 

Assets

 

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

17,205

 

 

$

13,576

 

Short-term investments

 

 

120,772

 

 

 

122,951

 

 

 

 

 

 

 

 

 

 

 

 

 

Total cash, cash equivalents, and short-term investments

 

 

137,977

 

 

 

136,527

 

Accounts receivable, net of allowance for doubtful accounts of $610 and $788

 

 

22,851

 

 

 

32,011

 

Inventories

 

 

2,705

 

 

 

1,895

 

Other current assets

 

 

13,544

 

 

 

11,482

 

 

 

 

 

 

 

 

 

 

 

 

 

Total current assets

 

 

177,077

 

 

 

181,915

 

Property and equipment, net of accumulated depreciation of $45,417 and $43,197

 

 

47,927

 

 

 

44,151

 

Operating lease right-of-use assets

 

 

9,047

 

 

 

8,753

 

Equity investments

 

 

3,103

 

 

 

2,965

 

Goodwill

 

 

43,890

 

 

 

43,351

 

Intangible assets, net

 

 

6,923

 

 

 

7,038

 

Other long-term assets

 

 

13,034

 

 

 

13,138

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

301,001

 

 

$

301,311

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Liabilities and stockholders’ equity

 

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

 

Accounts payable

 

$

12,509

 

 

$

12,530

 

Current portion of long-term debt

 

 

6,497

 

 

 

3,749

 

Accrued compensation

 

 

5,714

 

 

 

7,874

 

Short-term income taxes

 

 

2,384

 

 

 

2,130

 

Short-term unearned revenue

 

 

33,476

 

 

 

36,000

 

Other current liabilities

 

 

9,476

 

 

 

10,027

 

 

 

 

 

 

 

 

 

 

 

 

 

Total current liabilities

 

 

70,056

 

 

 

72,310

 

Long-term debt

 

 

57,055

 

 

 

59,578

 

Long-term income taxes

 

 

28,204

 

 

 

29,432

 

Long-term unearned revenue

 

 

2,829

 

 

 

3,180

 

Deferred income taxes

 

 

187

 

 

 

204

 

Operating lease liabilities

 

 

7,753

 

 

 

7,671

 

Other long-term liabilities

 

 

11,525

 

 

 

10,632

 

 

 

 

 

 

 

 

 

 

 

 

 

Total liabilities

 

 

177,609

 

 

 

183,007

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

 

 

 

Common stock and paid-in capital – shares authorized 24,000; outstanding 7,564 and 7,571

 

 

81,089

 

 

 

80,552

 

Retained earnings

 

 

39,193

 

 

 

34,566

 

Accumulated other comprehensive income

 

 

3,110

 

 

 

3,186

 

 

 

 

 

 

 

 

 

 

 

 

 

Total stockholders’ equity

 

 

123,392

 

 

 

118,304

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

301,001

 

 

$

301,311

 

 

 

 

 

 

 

 

 

 

 

Refer to accompanying notes.

 

5


PART I

Item 1

 

CASH FLOWS STATEMENTS

 

(In millions) (Unaudited)

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

2020

 

 

2019

 

 

 

 

Operations

 

 

 

 

 

 

 

 

Net income

 

$

13,893

 

 

$

10,678

 

Adjustments to reconcile net income to net cash from operations:

 

 

 

 

 

 

 

 

Depreciation, amortization, and other

 

 

2,645

 

 

 

2,971

 

Stock-based compensation expense

 

 

1,456

 

 

 

1,262

 

Net recognized losses (gains) on investments and derivatives

 

 

(128

)

 

 

11

 

Deferred income taxes

 

 

(11

)

 

 

(177

)

Changes in operating assets and liabilities:

 

 

 

 

 

 

 

 

Accounts receivable

 

 

8,843

 

 

 

10,090

 

Inventories

 

 

(808

)

 

 

(561

)

Other current assets

 

 

(54

)

 

 

(438

)

Other long-term assets

 

 

(62

)

 

 

(333

)

Accounts payable

 

 

315

 

 

 

(547

)

Unearned revenue

 

 

(3,064

)

 

 

(2,892

)

Income taxes

 

 

(983

)

 

 

(3,336

)

Other current liabilities

 

 

(2,951

)

 

 

(3,320

)

Other long-term liabilities

 

 

244

 

 

 

410

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net cash from operations

 

 

19,335

 

 

 

13,818

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Financing

 

 

 

 

 

 

 

 

Repayments of debt

 

 

0

 

 

 

(2,500

)

Common stock issued

 

 

545

 

 

 

427

 

Common stock repurchased

 

 

(6,743

)

 

 

(4,912

)

Common stock cash dividends paid

 

 

(3,856

)

 

 

(3,510

)

Other, net

 

 

(235

)

 

 

286

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net cash used in financing

 

 

(10,289

)

 

 

(10,209

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investing

 

 

 

 

 

 

 

 

Additions to property and equipment

 

 

(4,907

)

 

 

(3,385

)

Acquisition of companies, net of cash acquired, and purchases of intangible and other assets

 

 

(481

)

 

 

(462

)

Purchases of investments

 

 

(14,580

)

 

 

(23,390

)

Maturities of investments

 

 

14,266

 

 

 

19,082

 

Sales of investments

 

 

2,414

 

 

 

6,379

 

Other, net

 

 

(2,083

)

 

 

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net cash used in investing

 

 

(5,371

)

 

 

(1,776

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Effect of foreign exchange rates on cash and cash equivalents

 

 

(46

)

 

 

(72

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net change in cash and cash equivalents

 

 

3,629

 

 

 

1,761

 

Cash and cash equivalents, beginning of period

 

 

13,576

 

 

 

11,356

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents, end of period

 

$

17,205

 

 

$

13,117

 

 

 

 

 

 

 

 

 

 

 

Refer to accompanying notes.

 

6


PART I

Item 1

 

STOCKHOLDERS’ EQUITY STATEMENTS

 

(In millions) (Unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

2020

 

 

2019

 

 

 

 

 

 

 

Common stock and paid-in capital

 

 

 

 

 

 

 

 

 

Balance, beginning of period

 

$

80,552

 

 

$

78,520

 

 

Common stock issued

 

 

815

 

 

 

427

 

 

Common stock repurchased

 

 

(1,732

)

 

 

(1,326

)

 

Stock-based compensation expense

 

 

1,456

 

 

 

1,262

 

 

Other, net

 

 

(2

)

 

 

(1

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, end of period

 

 

81,089

 

 

 

78,882

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Retained earnings

 

 

 

 

 

 

 

 

 

Balance, beginning of period

 

 

34,566

 

 

 

24,150

 

 

Net income

 

 

13,893

 

 

 

10,678

 

 

Common stock cash dividends

 

 

(4,231

)

 

 

(3,887

)

 

Common stock repurchased

 

 

(5,003

)

 

 

(3,701

)

 

Cumulative effect of accounting changes

 

 

(32

)

 

 

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, end of period

 

 

39,193

 

 

 

27,240

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated other comprehensive income (loss)

 

 

 

 

 

 

 

 

 

Balance, beginning of period

 

 

3,186

 

 

 

(340

)

 

Other comprehensive income (loss)

 

 

(86

)

 

 

279

 

 

Cumulative effect of accounting changes

 

 

10

 

 

 

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, end of period

 

 

3,110

 

 

 

(61

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total stockholders’ equity

 

$

123,392

 

 

$

106,061

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash dividends declared per common share

 

$

0.56

 

 

$

0.51

 

 

 

 

 

 

 

 

 

 

 

 

 

Refer to accompanying notes.

7


PART I

Item 1

 

NOTES TO FINANCIAL STATEMENTS

(Unaudited)

 

NOTE 1 — ACCOUNTING POLICIES

Accounting Principles

Our unaudited interim consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). In the opinion of management, the unaudited interim consolidated financial statements reflect all adjustments of a normal recurring nature that are necessary for a fair presentation of the results for the interim periods presented. 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 fiscal year 2020 Form 10-K filed with the U.S. Securities and Exchange Commission (“SEC”) on July 30, 2020.

 

Principles of Consolidation

The consolidated financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated.

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 and assumptions include: for revenue recognition, determining the nature and timing of satisfaction of performance obligations, and determining the standalone selling price (“SSP”) of performance obligations, variable consideration, and other obligations such as product returns and refunds; loss contingencies; product warranties; the fair value of and/or potential impairment of goodwill and intangible assets for our reporting units; product life cycles; useful lives of our tangible and intangible assets; allowances for doubtful accounts; the market value of, and demand for, our inventory; stock-based compensation forfeiture rates; when technological feasibility is achieved for our products; the potential outcome of uncertain tax positions that have been recognized in our consolidated financial statements or tax returns; and determining the timing and amount of impairments for investments. Actual results and outcomes may differ from management’s estimates and assumptions due to risks and uncertainties, including uncertainty in the current economic environment due to the recent outbreak of a novel strain of the coronavirus (“COVID-19”).

In July 2020, we completed an assessment of the useful lives of our server and network equipment and determined we should increase the estimated useful life of server equipment from three years to four years and increase the estimated useful life of network equipment from two years to four years. This change in accounting estimate was effective beginning fiscal year 2021. Based on the carrying amount of server and network equipment included in property and equipment, net as of June 30, 2020, the effect of this change in estimate for the three months ended September 30, 2020, was an increase in operating income of $927 million and net income of $763 million, or $0.10 per both basic and diluted share.

Financial Instruments

Investments

We consider all highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. The fair values of these investments approximate their carrying values. In general, investments with original maturities of greater than three months and remaining maturities of less than one year are classified as short-term investments. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations.

8


PART I

Item 1

 

Debt investments are classified as available-for-sale and realized gains and losses are recorded using the specific identification method. Changes in fair value, excluding credit losses and impairments, are recorded in other comprehensive income. Fair value is calculated based on publicly available market information or other estimates determined by management. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, and the extent to which the fair value is less than cost. To determine credit losses, we employ a systematic methodology that considers available quantitative and qualitative evidence. In addition, we consider specific adverse conditions related to the financial health of, and business outlook for, the investee. If we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery, then a decline in fair value below cost is recorded as an impairment charge in other income (expense), net and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments.

Equity investments with readily determinable fair values are measured at fair value. Equity investments without readily determinable fair values are measured using the equity method or measured at cost with adjustments for observable changes in price or impairments (referred to as the measurement alternative). We perform a qualitative assessment on a periodic basis and recognize an impairment if there are sufficient indicators that the fair value of the investment is less than carrying value. Changes in value are recorded in other income (expense), net.

Derivatives

Derivative instruments are recognized as either assets or liabilities and 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, gains and losses are recognized in other income (expense), net with offsetting gains and losses on the hedged items. Gains and losses representing hedge components excluded from the assessment of effectiveness are recognized in other income (expense), net.

For derivative instruments designated as cash flow hedges, gains and losses are initially reported as a component of other comprehensive income and subsequently recognized in earnings with the corresponding hedged item. Gains and losses representing hedge components excluded from the assessment of effectiveness are recognized in earnings.

For derivative instruments that are not designated as hedges, gains and losses from changes in fair values are primarily recognized in other income (expense), net.

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 in active markets. Our Level 1 investments include U.S. government securities, common and preferred stock, and mutual funds. Our Level 1 derivative assets and liabilities include those actively traded on exchanges.

 

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

9


PART I

Item 1

 

 

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 assets and liabilities include investments in corporate notes and bonds, municipal securities, and goodwill and intangible assets, when they are recorded at fair value due to an impairment charge. Unobservable inputs used in the models are significant to the fair values of the assets and liabilities.

We measure equity investments without readily determinable fair values on a nonrecurring basis. 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.

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

Contract Balances and Other Receivables

As of September 30, 2020 and June 30, 2020, other receivables due from suppliers were $1.1 billion and $442 million, respectively, and are included in accounts receivable, net in our consolidated balance sheets.

As of both September 30, 2020 and June 30, 2020, long-term accounts receivable, net of allowance for doubtful accounts was $2.7 billion and is included in other long-term assets in our consolidated balance sheets.

 

We record financing receivables when we offer certain of our customers the option to acquire our software products and services offerings through a financing program in a limited number of countries. As of September 30, 2020 and June 30, 2020, financing receivables, net were $4.8 billion and $5.2 billion, respectively, for short-term and long-term financing receivables, which are included in other current assets and other long-term assets in our consolidated balance sheets. We record an allowance to cover expected losses based on troubled accounts, historical experience, and other currently available evidence.

 

Recent Accounting Guidance

Recently Adopted Accounting Guidance

Financial Instruments – Credit Losses

In June 2016, the FASB issued a new standard to replace the incurred loss impairment methodology under current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. We adopted the standard effective July 1, 2020. We use a forward-looking expected credit loss model for accounts receivable, loans, and other financial instruments. Credit losses relating to available-for-sale debt securities are recorded through an allowance for credit losses rather than as a reduction in the amortized cost basis of the securities. We applied a modified retrospective approach through a cumulative-effect adjustment to retained earnings as of the effective date to align our credit loss methodology with the new standard. The adoption of the standard did not have a material impact on our consolidated financial statements.

Recent Accounting Guidance Not Yet Adopted

Accounting for Income Taxes

In December 2019, the FASB issued a new standard to simplify the accounting for income taxes. The guidance eliminates certain exceptions related to the approach for intraperiod tax allocation, the methodology for calculating income taxes in an interim period, and the recognition of deferred tax liabilities for outside basis differences related to changes in ownership of equity method investments and foreign subsidiaries. The guidance also simplifies aspects of accounting for franchise taxes and enacted changes in tax laws or rates, and clarifies the accounting for transactions that result in a step-up in the tax basis of goodwill. The standard will be effective for us beginning July 1, 2021, with early adoption permitted. We are currently evaluating the impact of this standard in our consolidated financial statements, including accounting policies, processes, and systems.

 

10


PART I

Item 1

 

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 and stock awards.

The components of basic and diluted EPS were as follows:

 

(In millions, except earnings per share)

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

2020

 

 

2019

 

 

 

 

 

 

 

 

 

 

Net income available for common shareholders (A)

 

$

13,893

 

 

$

10,678

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average outstanding shares of common stock (B)

 

 

7,566

 

 

 

7,634

 

Dilutive effect of stock-based awards

 

 

71

 

 

 

76

 

 

 

 

 

 

 

 

 

 

 

 

 

Common stock and common stock equivalents (C)

 

 

7,637

 

 

 

7,710

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings Per Share

 

 

 

 

 

 

 

 

 

 

 

 

Basic (A/B)

 

$

1.84

 

 

$

1.40

 

Diluted (A/C)

 

$

1.82

 

 

$

1.38

 

 

 

 

 

 

 

 

 

 

 

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

 

NOTE 3 — OTHER INCOME (EXPENSE), NET

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

 

(In millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

2020

 

 

2019

 

 

 

 

 

 

 

 

 

 

Interest and dividends income

 

$

570

 

 

$

724

 

Interest expense

 

 

(589

)

 

 

(637

)

Net recognized gains (losses) on investments

 

 

125

 

 

 

(57

)

Net gains on derivatives

 

 

3

 

 

 

46

 

Net gains (losses) on foreign currency remeasurements

 

 

139

 

 

 

(58

)

Other, net

 

 

0

 

 

 

(18

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

248

 

 

$

0

 

 

 

 

 

 

 

 

 

 

 

Net Recognized Gains (Losses) on Investments

Net recognized gains (losses) on debt investments were as follows:

 

(In millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

2020

 

 

2019

 

 

 

 

 

 

 

 

 

 

Realized gains from sales of available-for-sale securities

 

$

19

 

 

$

    7

 

Realized losses from sales of available-for-sale securities

 

 

(5

)

 

 

(4

)

Impairments and allowance for credit losses

 

 

3

 

 

 

(4

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

17

 

 

$

(1

)

 

 

 

 

 

 

 

 

 

 

11


PART I

Item 1

 

Net recognized gains (losses) on equity investments were as follows:

 

(In millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

 

2020

 

 

 

2019

 

 

 

 

 

 

 

 

 

 

Net realized gains on investments sold

 

$

17

 

 

$

22

 

Net unrealized gains (losses) on investments still held

 

 

100

 

 

 

(56

)

Impairments of investments

 

 

(9

)

 

 

(22

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

108

 

 

$

(56

)

 

 

 

 

 

 

 

 

 

 

NOTE 4 — INVESTMENTS

Investment Components

The components of investments were as follows:

 

(In millions)

 

Fair Value
Level

 

 

 

Adjusted

Cost Basis

 

 

 

Unrealized

Gains

 

 

 

Unrealized

Losses

 

 

 

Recorded

Basis

 

 

 

Cash

 and Cash

Equivalents

 

 

 

Short-term

Investments

 

 

 

Equity

Investments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

September 30, 2020

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Changes in Fair Value Recorded in Other Comprehensive Income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial paper

 

Level 2

 

 

$

5,128

 

 

$

0

 

 

$

0

 

 

$

5,128

 

 

$

2,869

 

 

$

2,259

 

 

$

0

 

Certificates of deposit

 

Level 2

 

 

 

2,674

 

 

 

0

 

 

 

0

 

 

 

2,674

 

 

 

1,781

 

 

 

893

 

 

 

0

 

U.S. government securities

 

Level 1

 

 

 

93,143

 

 

 

6,230

 

 

 

0

 

 

 

99,373

 

 

 

4,556

 

 

 

94,817

 

 

 

0

 

U.S. agency securities

 

Level 2

 

 

 

3,339

 

 

 

3

 

 

 

0

 

 

 

3,342

 

 

 

1,550

 

 

 

1,792

 

 

 

0

 

Foreign government bonds

 

Level 2

 

 

 

7,054

 

 

 

7

 

 

 

(3

)

 

 

7,058

 

 

 

0

 

 

 

7,058

 

 

 

0

 

Mortgage- and asset-backed securities

 

Level 2

 

 

 

4,764

 

 

 

42

 

 

 

(4

)

 

 

4,802

 

 

 

0

 

 

 

4,802

 

 

 

0

 

Corporate notes and bonds

 

Level 2

 

 

 

8,287

 

 

 

332

 

 

 

(5

)

 

 

8,614

 

 

 

0

 

 

 

8,614

 

 

 

0

 

Corporate notes and bonds

 

Level 3

 

 

 

52

 

 

 

0

 

 

 

0

 

 

 

52

 

 

 

0

 

 

 

52

 

 

 

0

 

Municipal securities

 

Level 2

 

 

 

312

 

 

 

60

 

 

 

(3

)

 

 

369

 

 

 

0

 

 

 

369

 

 

 

0

 

Municipal securities

 

Level 3

 

 

 

95

 

 

 

0

 

 

 

(7

)

 

 

88

 

 

 

0

 

 

 

88

 

 

 

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total debt investments

 

 

 

 

$

124,848

 

 

$

6,674

 

 

$

(22

)

 

$

131,500

 

 

$

10,756

 

 

$

120,744

 

 

$

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Changes in Fair Value Recorded in Net Income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Equity investments

 

Level 1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

1,170

 

 

$

724

 

 

$

0

 

 

$

446

 

Equity investments

 

Other

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2,657

 

 

 

0

 

 

 

0

 

 

 

2,657

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total equity investments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

3,827

 

 

$

724

 

 

$

0

 

 

$

3,103

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

5,725

 

 

$

5,725

 

 

$

0

 

 

$

0

 

Derivatives, net (a)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

28

 

 

 

0

 

 

 

28

 

 

 

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

141,080

 

 

$

17,205

 

 

$

120,772

 

 

$

3,103

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

12


PART I

Item 1

 

 

(In millions)

 

Fair Value
Level

 

 

 

Adjusted

Cost Basis

 

 

 

Unrealized

Gains

 

 

 

Unrealized

Losses

 

 

 

Recorded

Basis

 

 

 

Cash

and Cash

Equivalents

 

 

 

Short-term

Investments

 

 

 

Equity

Investments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

June 30, 2020

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Changes in Fair Value Recorded in Other Comprehensive Income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial paper

 

Level 2

 

 

$

4,687

 

 

$

1

 

 

$

0

 

 

$

4,688

 

 

$

1,618

 

 

$

3,070

 

 

$

0

 

Certificates of deposit

 

Level 2

 

 

 

2,898

 

 

 

0

 

 

 

0

 

 

 

2,898

 

 

 

1,646

 

 

 

1,252

 

 

 

0

 

U.S. government securities

 

Level 1

 

 

 

92,067

 

 

 

6,495

 

 

 

(1

)

 

 

98,561

 

 

 

3,168

 

 

 

95,393

 

 

 

0

 

U.S. agency securities

 

Level 2

 

 

 

2,439

 

 

 

2

 

 

 

0

 

 

 

2,441

 

 

 

449

 

 

 

1,992

 

 

 

0

 

Foreign government bonds

 

Level 2

 

 

 

6,982

 

 

 

6

 

 

 

(3

)

 

 

6,985

 

 

 

1

 

 

 

6,984

 

 

 

0

 

Mortgage- and asset-backed securities

 

Level 2

 

 

 

4,865

 

 

 

41

 

 

 

(6

)

 

 

4,900

 

 

 

0

 

 

 

4,900

 

 

 

0

 

Corporate notes and bonds

 

Level 2

 

 

 

8,500

 

 

 

327

 

 

 

(17

)

 

 

8,810

 

 

 

0

 

 

 

8,810

 

 

 

0

 

Corporate notes and bonds

 

Level 3

 

 

 

58

 

 

 

0

 

 

 

0

 

 

 

58

 

 

 

0

 

 

 

58

 

 

 

0

 

Municipal securities

 

Level 2

 

 

 

313

 

 

 

57

 

 

 

(4

)

 

 

366

 

 

 

0

 

 

 

366

 

 

 

0

 

Municipal securities

 

Level 3

 

 

 

91

 

 

 

0

 

 

 

0

 

 

 

91

 

 

 

0

 

 

 

91

 

 

 

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total debt investments

 

 

 

 

$

122,900

 

 

$

6,929

 

 

$

(31

)

 

$

129,798

 

 

$

6,882

 

 

$

122,916

 

 

$

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Changes in Fair Value Recorded in Net Income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Equity investments

 

Level 1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

1,198

 

 

$

784

 

 

$

0

 

 

$

414

 

Equity investments

 

Other

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2,551

 

 

 

0

 

 

 

0

 

 

 

2,551

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total equity investments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

3,749

 

 

$

784

 

 

$

0

 

 

$

2,965

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

5,910

 

 

$

5,910

 

 

$

0

 

 

$

0

 

Derivatives, net (a)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

35

 

 

 

0

 

 

 

35

 

 

 

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

139,492

 

 

$

13,576

 

 

$

122,951

 

 

$

2,965

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(a)

Refer to Note 5 – Derivatives for further information on the fair value of our derivative instruments.

Equity investments presented as “Other” in the tables above include investments without readily determinable fair values measured using the equity method or measured at cost with adjustments for observable changes in price or impairments, and investments measured at fair value using net asset value as a practical expedient which are not categorized in the fair value hierarchy. As of both September 30, 2020 and June 30, 2020, equity investments without readily determinable fair values measured at cost with adjustments for observable changes in price or impairments were $1.4 billion.

Unrealized Losses on Debt Investments

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

 

 

 

Less than 12 Months

 

 

12 Months or Greater

 

 

 

 

 

 

 

Total
Unrealized
Losses

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(In millions)

 

 

Fair Value

 

 

 

Unrealized
Losses

 

 

 

Fair Value

 

 

 

Unrealized
Losses

 

 

 

Total
Fair Value

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

September 30, 2020

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. government and agency securities

 

$

1,847

 

 

$

0

 

 

$

0

 

 

$

0

 

 

$

1,847

 

 

$

0

 

Foreign government bonds

 

 

977

 

 

 

(3

)

 

 

0

 

 

 

0

 

 

 

977

 

 

 

(3

)

Mortgage- and asset-backed securities

 

 

832

 

 

 

(4

)

 

 

0

 

 

 

0

 

 

 

832

 

 

 

(4

)

Corporate notes and bonds

 

 

421

 

 

 

(5

)

 

 

0

 

 

 

0

 

 

 

421

 

 

 

(5

)

Municipal securities

 

 

119

 

 

 

(10

)

 

 

0

 

 

 

0

 

 

 

119

 

 

 

(10

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

4,196

 

 

$

    (22

)

 

$

    0

 

 

$

0

 

 

$

  4,196

 

 

$

    (22

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

13


PART I

Item 1

 

 

 

 

Less than 12 Months

 

 

12 Months or Greater

 

 

 

 

 

 

 

Total
Unrealized
Losses

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(In millions)

 

 

Fair Value

 

 

 

Unrealized
Losses

 

 

 

Fair Value

 

 

 

Unrealized
Losses

 

 

 

Total
Fair Value

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

June 30, 2020

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. government and agency securities

 

$

2,323

 

 

$

(1

)

 

$

0

 

 

$

0

 

 

$

2,323

 

 

$

(1

)

Foreign government bonds

 

 

500

 

 

 

(3

)

 

 

0

 

 

 

0

 

 

 

500

 

 

 

(3

)

Mortgage- and asset-backed securities

 

 

1,014

 

 

 

(6

)

 

 

0

 

 

 

0

 

 

 

1,014

 

 

 

(6

)

Corporate notes and bonds

 

 

649

 

 

 

(17

)

 

 

0

 

 

 

0

 

 

 

649

 

 

 

(17

)

Municipal securities

 

 

66

 

 

 

(4

)

 

 

0

 

 

 

0

 

 

 

66

 

 

 

(4

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

4,552

 

 

$

  (31

)

 

$

  0

 

 

$

  0

 

 

$

 4,552

 

 

$

  (31

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Management does not believe any remaining unrealized losses represent impairments based on our evaluation of available evidence.

Debt Investment Maturities

 

(In millions)

 

Adjusted

Cost Basis

 

 

Estimated

Fair Value

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

September 30, 2020

 

 

 

 

 

 

 

 

 

 

 

Due in one year or less

 

$

35,327

 

 

$

35,397

 

Due after one year through five years

 

 

55,735

 

 

 

59,048

 

Due after five years through 10 years

 

 

30,786

 

 

 

33,870

 

Due after 10 years

 

 

3,000

 

 

 

3,185

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

  124,848

 

 

$

  131,500

 

 

 

 

 

 

 

 

 

 

 

NOTE 5 — DERIVATIVES

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

Foreign Currencies

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.

Foreign currency risks related to certain non-U.S. dollar-denominated investments are hedged using foreign exchange forward contracts that are designated as fair value hedging instruments. Foreign currency risks related to certain Euro-denominated debt are hedged using foreign exchange forward contracts that are designated as cash flow hedging instruments.

In the past, option and forward contracts were used to hedge a portion of forecasted international revenue and were designated as cash flow hedging instruments. Principal currencies hedged included the Euro, Japanese yen, British pound, Canadian dollar, and Australian dollar.

Certain options and forwards not designated as hedging instruments are also used to manage the variability in foreign exchange rates on certain balance sheet amounts and to manage other foreign currency exposures.

Interest Rate

Interest rate risks related to certain fixed-rate debt are hedged using interest rate swaps that are designated as fair value hedging instruments to effectively convert the fixed interest rates to floating interest rates.

14


PART I

Item 1

 

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. These contracts are not designated as hedging instruments and are included in “Other contracts” in the tables below.

Equity

Securities held in our equity investments portfolio are subject to market price risk. At times, we may hold options, futures, and swap contracts. These contracts are not designated as hedging instruments and are included in “Other contracts” in the tables below.

Credit

Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. These contracts are not designated as hedging instruments and are included in “Other contracts” in the tables below.

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 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 September 30, 2020, 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.

The following table presents the notional amounts of our outstanding derivative instruments measured in U.S. dollar equivalents:

 

(In millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

September 30,

2020

 

 

June 30,

2020

 

 

 

 

 

 

 

 

Designated as Hedging Instruments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts purchased

 

$

635

 

 

$

635

 

Foreign exchange contracts sold

 

 

6,844

 

 

 

6,754

 

Interest rate contracts purchased

 

 

1,292

 

 

 

1,295

 

 

 

 

 

 

 

 

 

 

Not Designated as Hedging Instruments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts purchased

 

 

11,935

 

 

 

11,896

 

Foreign exchange contracts sold

 

 

10,903

 

 

 

15,595

 

Other contracts purchased

 

 

2,202

 

 

 

1,844

 

Other contracts sold

 

 

749

 

 

 

757

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

15


PART I

Item 1

 

Fair Values of Derivative Instruments

The following table presents our derivative instruments:

 

 

 

Derivative

 

 

 

Derivative

 

 

Derivative

 

 

Derivative

 

(In millions)

 

Assets

 

 

 

Liabilities

 

 

Assets

 

 

Liabilities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

September 30,

2020

 

 

June 30,

2020

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Designated as Hedging Instruments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

$

16

 

 

$

(67

)

 

$

44

 

 

$

(54

)

Interest rate contracts

 

 

89

 

 

 

0

 

 

 

93

 

 

 

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Not Designated as Hedging Instruments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

 

165

 

 

 

(247

)

 

 

245

 

 

 

(334

)

Other contracts

 

 

6

 

 

 

(27

)

 

 

18

 

 

 

(11

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross amounts of derivatives

 

 

276

 

 

 

(341

)

 

 

400

 

 

 

(399

)

Gross amounts of derivatives offset in the balance sheet

 

 

(74

)

 

 

76

 

 

 

(154

)

 

 

158

 

Cash collateral received

 

 

0

 

 

 

(58

)

 

 

0

 

 

 

(154

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net amounts of derivatives

 

$

202

 

 

$

(323

)

 

$

246

 

 

$

(395

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Reported as

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Short-term investments

 

$

28

 

 

$

0

 

 

$

35

 

 

$

0

 

Other current assets

 

 

81

 

 

 

0

 

 

 

199

 

 

 

0

 

Other long-term assets

 

 

93

 

 

 

0

 

 

 

12

 

 

 

0

 

Other current liabilities

 

 

0

 

 

 

(232

)

 

 

0

 

 

 

(334

)

Other long-term liabilities

 

 

0

 

 

 

(91

)

 

 

0

 

 

 

(61

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

202

 

 

$

(323

)

 

$

246

 

 

$

(395

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross derivative assets and liabilities subject to legally enforceable master netting agreements for which we have elected to offset were $274 million and $340 million, respectively, as of September 30, 2020, and $399 million and $399 million, respectively, as of June 30, 2020.

The following table presents the fair value of our derivatives instruments on a gross basis:

 

(In millions)

 

Level 1

 

 

 

Level 2

 

 

Level 3

 

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

September 30, 2020

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Derivative assets

 

$

0

 

 

$

275

 

 

$

1

 

 

$

276

 

Derivative liabilities

 

 

0

 

 

 

(341

)

 

 

0

 

 

 

(341

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

June 30, 2020

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Derivative assets

 

 

1

 

 

 

398

 

 

 

1

 

 

 

400

 

Derivative liabilities

 

 

0

 

 

 

(399

)

 

 

0

 

 

 

(399

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

16


PART I

Item 1

 

Gains (losses) on derivative instruments recognized in our consolidated income statements were as follows:

 

(In millions)

 

Revenue

 

 

Other Income

(Expense), Net

 

 

Revenue

 

 

Other Income

(Expense), Net

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

2020

 

 

2019

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Designated as Fair Value Hedging Instruments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Derivatives

 

$

0

 

 

$

(169

)

 

$

0

 

 

$

30

 

Hedged items

 

 

0

 

 

 

168

 

 

 

0

 

 

 

(33

)

Excluded from effectiveness assessment

 

 

0

 

 

 

8

 

 

 

0

 

 

 

41

 

Interest rate contracts

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Derivatives

 

 

0

 

 

 

0

 

 

 

0

 

 

 

1

 

Hedged items

 

 

0

 

 

 

4

 

 

 

0

 

 

 

(1

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Designated as Cash Flow Hedging Instruments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amount reclassified from accumulated other comprehensive income

 

 

0

 

 

 

20

 

 

 

0

 

 

 

(5

)

Excluded from effectiveness assessment

 

 

0

 

 

 

0

 

 

 

0

 

 

 

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Not Designated as Hedging Instruments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

 

0

 

 

 

58

 

 

 

0

 

 

 

(171

)

Other contracts

 

 

0

 

 

 

4

 

 

 

0

 

 

 

1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gains (losses), net of tax, on derivative instruments recognized in our consolidated comprehensive income statements were as follows:

 

(In millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

2020

 

 

2019

 

 

 

 

 

 

 

 

 

 

Designated as Cash Flow Hedging Instruments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

 

 

 

 

 

 

 

Included in effectiveness assessment

 

$

20

 

 

$

(6

)

 

 

 

 

 

 

 

NOTE 6 — INVENTORIES

The components of inventories were as follows:

 

(In millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

September 30,

2020

 

 

June 30,

2020

 

 

 

 

Raw materials

 

$

796

 

 

$

700

 

Work in process

 

 

83

 

 

 

83

 

Finished goods

 

 

1,826

 

 

 

1,112

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

2,705

 

 

$

1,895

 

 

 

 

 

 

 

 

 

 

 

 

NOTE 7 — BUSINESS COMBINATIONS

On September 19, 2020, we entered into a definitive agreement to acquire ZeniMax Media Inc., the parent company of Bethesda Softworks LLC (“Bethesda”), for $7.5 billion in cash. Bethesda is one of the largest, privately held game developers and publishers in the world, and will bring a broad portfolio of games, technology, and talent to Xbox. We expect this acquisition to close in the second half of fiscal year 2021, subject to customary closing conditions and completion of regulatory review.

 

17


PART I

Item 1

 

NOTE 8 — GOODWILL

Changes in the carrying amount of goodwill were as follows:

 

(In millions)

 

June 30,

2020

 

 

Acquisitions

 

 

Other

 

 

September 30,

2020

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Productivity and Business Processes

 

$

24,190

 

 

$

0

 

 

$

33

 

 

$

24,223

 

Intelligent Cloud

 

 

12,697

 

 

 

443

 

 

 

1

 

 

 

13,141

 

More Personal Computing

 

 

6,464

 

 

 

0

 

 

 

62

 

 

 

6,526

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

43,351

 

 

$

443

 

 

$

96

 

 

$

43,890

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The measurement periods for the valuation of assets acquired and liabilities assumed end as soon as information on the facts and circumstances that existed as of the acquisition dates becomes available, but do not exceed 12 months. Adjustments in purchase price allocations may require a change in the amounts allocated to goodwill during the periods in which the adjustments are determined.

Any change in the goodwill amounts resulting from foreign currency translations and purchase accounting adjustments are presented as “Other” in the table above. Also included in “Other” are business dispositions and transfers between segments due to reorganizations, as applicable.

 

NOTE 9  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

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

September 30,

2020

 

 

June 30,

2020

 

 

 

 

 

 

 

 

Technology-based

 

$

8,327

 

 

$

(6,527

)

 

$

1,800

 

 

$

8,160

 

 

$

(6,381

)

 

$

1,779

 

Customer-related

 

 

5,066

 

 

 

(2,482

)

 

 

2,584

 

 

 

4,967

 

 

 

(2,320

)

 

 

2,647

 

Marketing-related

 

 

4,159

 

 

 

(1,655

)

 

 

2,504

 

 

 

4,158

 

 

 

(1,588

)

 

 

2,570

 

Contract-based

 

 

475

 

 

 

(440

)

 

 

35

 

 

 

474

 

 

 

(432

)

 

 

42

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

18,027

 

 

$

(11,104

)

 

$

6,923

 

 

$

17,759

 

 

$

(10,721

)

 

$

7,038

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Intangible assets amortization expense was $383 million and $434 million for the three months ended September 30, 2020 and 2019, respectively.

The following table outlines the estimated future amortization expense related to intangible assets held as of September 30, 2020:

 

(In millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ending June 30,

 

 

 

 

 

 

2021 (excluding the three months ended September 30, 2020)

 

$

1,150

 

2022

 

 

1,461

 

2023

 

 

1,267

 

2024

 

 

904

 

2025

 

 

487

 

Thereafter

 

 

1,654

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

6,923

 

 

 

 

 

 

 

18


PART I

Item 1

 

NOTE 10  DEBT

The components of debt were as follows:

 

(In millions, issuance by calendar year)

 

Maturities

(calendar year)

 

Stated Interest

Rate

 

 

Effective Interest

Rate

 

 

September 30,

2020

 

 

June 30,

2020

 

 

 

 

 

��

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2009 issuance of $3.8 billion (a)

 

 

 

 

2039

 

 

 

 

5.20%

 

 

 

 

5.24%

 

 

$

559

 

 

$

559

 

2010 issuance of $4.8 billion (a)

 

 

2020

2040

 

 

3.00%

4.50%

 

 

3.14%

4.57%

 

 

 

1,571

 

 

 

1,571

 

2011 issuance of $2.3 billion (a)

 

 

2021

2041

 

 

4.00%

5.30%

 

 

4.08%

5.36%

 

 

 

1,270

 

 

 

1,270

 

2012 issuance of $2.3 billion

 

 

2022

2042

 

 

2.13%

3.50%

 

 

2.24%

3.57%

 

 

 

1,650

 

 

 

1,650

 

2013 issuance of $5.2 billion (a)

 

 

2023

2043

 

 

2.38%

4.88%

 

 

2.47%

4.92%

 

 

 

2,919

 

 

 

2,919

 

2013 issuance of €4.1 billion

 

 

2021

2033

 

 

2.13%

3.13%

 

 

2.23%

3.22%

 

 

 

4,748

 

 

 

4,549

 

2015 issuance of $23.8 billion (a)

 

 

2020

2055

 

 

2.00%

4.75%

 

 

2.09%

4.78%

 

 

 

15,549

 

 

 

15,549

 

2016 issuance of $19.8 billion (a)

 

 

2021

2056

 

 

1.55%

3.95%

 

 

1.64%

4.03%

 

 

 

16,955

 

 

 

16,955

 

2017 issuance of $17.0 billion (a)

 

 

2022

2057

 

 

2.40%

4.50%

 

 

2.52%

4.53%

 

 

 

12,385

 

 

 

12,385

 

2020 issuance of $10.0 billion (a)

 

 

2050

2060

 

 

2.53%

2.68%

 

 

2.53%

2.68%

 

 

 

10,000

 

 

 

10,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total face value

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

67,606

 

 

 

67,407

 

Unamortized discount and issuance costs

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(542

)

 

 

(554

)

Hedge fair value adjustments (b)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

89

 

 

 

93

 

Premium on debt exchange (a)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(3,601

)

 

 

(3,619

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total debt

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

63,552

 

 

 

63,327

 

Current portion of long-term debt

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(6,497

)

 

 

(3,749

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Long-term debt

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

57,055

 

 

$

59,578

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(a)

In June 2020, we exchanged a portion of our existing debt at premium for cash and new debt with longer maturities. The premium will be amortized over the term of the new debt.

(b)

Refer to Note 5 – Derivatives for further information on the interest rate swaps related to fixed-rate debt.

As of September 30, 2020 and June 30, 2020, the estimated fair value of long-term debt, including the current portion, was $77.7 billion and $77.1 billion, respectively. The estimated fair values are based on Level 2 inputs.

Debt in the table above is comprised of senior unsecured obligations and ranks equally with our other outstanding obligations. Interest is paid semi-annually, except for the Euro-denominated debt, which is paid annually.

The following table outlines maturities of our long-term debt, including the current portion, as of September 30, 2020:

 

(In millions)

  

 

  

 

 

 

 

 

 

 

 

 

 

Year Ending June 30,

 

 

 

 

 

 

 

 

 

2021 (excluding the three months ended September 30, 2020)

 

$

3,750

 

2022

 

 

8,052

 

2023

 

 

2,750

 

2024

 

 

5,250

 

2025

 

 

2,250

 

Thereafter

 

 

45,554

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

67,606

 

 

 

 

 

 

 

19


PART I

Item 1

 

NOTE 11 — INCOME TAXES

Effective Tax Rate

Our effective tax rate was 14% and 16% for the three months ended September 30, 2020 and 2019, respectively. The decrease in our effective tax rate for the current quarter compared to the prior year was primarily due to an increase in tax benefits relating to stock-based compensation.

Our effective tax rate was lower than the U.S. federal statutory rate for the three months ended September 30, 2020, 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 and Puerto Rico, and tax benefits relating to stock-based compensation.

Uncertain Tax Positions

As of September 30, 2020 and June 30, 2020, unrecognized tax benefits and other income tax liabilities were $16.9 billion and $16.6 billion, respectively, and are included in long-term income taxes in our consolidated balance sheets.

We settled a portion of the Internal Revenue Service (“IRS”) audit for tax years 2004 to 2006 in fiscal year 2011. In February 2012, the IRS withdrew its 2011 Revenue Agents Report related to unresolved issues for tax years 2004 to 2006 and reopened the audit phase of the examination. We also settled a portion of the IRS audit for tax years 2007 to 2009 in fiscal year 2016, and a portion of the IRS audit for tax years 2010 to 2013 in fiscal year 2018. We remain under audit for tax years 2004 to 2017.

As of September 30, 2020, the primary unresolved issues for the IRS audits relate to transfer pricing, which could have a material impact in our consolidated financial statements when the matters are resolved. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved key transfer pricing issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months.

We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2020, some of which are currently under audit by local tax authorities. The resolution of each of these audits is not expected to be material to our consolidated financial statements.

 

NOTE 12 — UNEARNED REVENUE

Unearned revenue by segment was as follows:

 

(In millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

September 30,
2020

 

 

June 30,
2020

 

 

 

 

Productivity and Business Processes

 

$

17,675

 

 

$

18,643

 

Intelligent Cloud

 

 

15,039

 

 

 

16,620

 

More Personal Computing

 

 

3,591

 

 

 

3,917

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

36,305

 

 

$

39,180

 

 

 

 

 

 

 

 

 

 

 

Changes in unearned revenue were as follows:

 

(In millions)

 

 

 

 

 

 

 

Three Months Ended September 30, 2020

 

 

 

Balance, beginning of period

 

$

39,180

 

Deferral of revenue

 

 

17,976

 

Recognition of unearned revenue

 

 

(20,851

)

 

 

 

 

 

 

 

Balance, end of period

 

$

36,305

 

 

 

 

 

 

 

20


PART I

Item 1

 

Revenue allocated to remaining performance obligations, which includes unearned revenue and amounts that will be invoiced and recognized as revenue in future periods, was $111 billion as of September 30, 2020, of which $107 billion is related to the commercial portion of revenue. We expect to recognize approximately 50% of this revenue over the next 12 months and the remainder thereafter.

 

 

NOTE 13  LEASES

We have operating and finance leases for datacenters, corporate offices, research and development facilities, retail stores, and certain equipment. Our leases have remaining lease terms of 1 year to 20 years, some of which include options to extend the leases for up to 5 years, and some of which include options to terminate the leases within 1 year.

The components of lease expense were as follows:

 

(In millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

 

2020

 

 

 

2019

 

 

 

 

 

 

 

 

 

 

Operating lease cost

 

$

498

 

 

$

465

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance lease cost:

 

 

 

 

 

 

 

 

Amortization of right-of-use assets

 

$

206

 

 

$

125

 

Interest on lease liabilities

 

 

92

 

 

 

78

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total finance lease cost

 

$

298

 

 

$

203

 

 

 

 

 

 

 

 

 

 

 

Supplemental cash flow information related to leases was as follows:

 

(In millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

 

2020

 

 

 

2019

 

 

 

 

 

 

 

 

 

 

Cash paid for amounts included in the measurement of lease liabilities:

 

 

 

 

 

 

 

 

Operating cash flows from operating leases

 

$

491

 

 

$

453

 

Operating cash flows from finance leases

 

 

92

 

 

 

78

 

Financing cash flows from finance leases

 

 

136

 

 

 

79

 

 

 

 

 

 

 

 

 

 

Right-of-use assets obtained in exchange for lease obligations:

 

 

 

 

 

 

 

 

Operating leases

 

 

678

 

 

 

983

 

Finance leases

 

 

635

 

 

 

1,489

 

 

 

 

 

 

 

 

 

 

 

21


PART I

Item 1

 

Supplemental balance sheet information related to leases was as follows:

 

(In millions, except lease term and discount rate)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

September 30,

2020

 

 

June 30,
2020

 

 

 

 

Operating Leases

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating lease right-of-use assets

 

$

9,047

 

 

$

8,753

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other current liabilities

 

$

1,744

 

 

$

1,616

 

Operating lease liabilities

 

 

7,753

 

 

 

7,671

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total operating lease liabilities

 

$

9,497

 

 

$

9,287

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance Leases

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Property and equipment, at cost

 

$

11,174

 

 

$

10,371

 

Accumulated depreciation

 

 

(1,591

)

 

 

(1,385

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Property and equipment, net

 

$

9,583

 

 

$

8,986

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other current liabilities

 

$

596

 

 

$

540

 

Other long-term liabilities

 

 

9,571

 

 

 

8,956

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total finance lease liabilities

 

$

10,167

 

 

$

9,496

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted Average Remaining Lease Term

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating leases

 

 

7 years

 

 

 

8 years

 

Finance leases

 

 

12 years

 

 

 

13 years

 

 

 

 

 

 

 

 

 

 

Weighted Average Discount Rate

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating leases

 

 

2.6%

 

 

 

2.7%

 

Finance leases

 

 

3.8%

 

 

 

3.9%

 

 

 

 

 

 

 

 

 

 

 

Maturities of lease liabilities were as follows:

 

(In millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ending June 30,

 

Operating Leases

 

 

Finance Leases

 

 

 

 

2021 (excluding the three months ended September 30, 2020)

 

$

1,522

 

 

$

709

 

2022

 

 

1,738

 

 

 

958

 

2023

 

 

1,566

 

 

 

968

 

2024

 

 

1,362

 

 

 

982

 

2025

 

 

1,090

 

 

 

1,304

 

Thereafter

 

 

3,513

 

 

 

7,805

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total lease payments

 

 

10,791

 

 

 

12,726

 

Less imputed interest

 

 

(1,294

)

 

 

(2,559

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

9,497

 

 

$

10,167

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

As of September 30, 2020, we have additional operating and finance leases, primarily for datacenters, that have not yet commenced of $4.3 billion and $4.6 billion, respectively. These operating and finance leases will commence between fiscal year 2021 and fiscal year 2024 with lease terms of 1 year to 16 years.

 

 

22


PART I

Item 1

 

NOTE 14 — CONTINGENCIES

Patent and Intellectual Property Claims

There were 70 patent infringement cases pending against Microsoft as of September 30, 2020, none of which are material individually or in aggregate.

Antitrust, Unfair Competition, and Overcharge Class Actions

Antitrust and unfair competition class action lawsuits were filed against us in British Columbia, Ontario, and Quebec, Canada. All three have been certified on behalf of Canadian indirect purchasers who acquired licenses for Microsoft operating system software and/or productivity application software between 1998 and 2010.

The trial of the British Columbia action commenced in May 2016. Following a mediation, the parties agreed to a global settlement of all three Canadian actions, and submitted the proposed settlement agreement to the courts in all three jurisdictions for approval. The final settlement and form of notice have been approved by the courts in British Columbia, Ontario, and Quebec. The ten month claims period will commence upon distribution of notice to the class, which we anticipate to occur in the second quarter of fiscal year 2021.

Other Antitrust Litigation and Claims

China State Administration for Industry and Commerce Investigation

In 2014, Microsoft was informed that China’s State Agency for Market Regulation (“SAMR”) (formerly State Administration for Industry and Commerce) had begun a formal investigation relating to China’s Anti-Monopoly Law, and the SAMR conducted onsite inspections of Microsoft offices in Beijing, Shanghai, Guangzhou, and Chengdu. The SAMR has presented its preliminary views as to certain possible violations of China's Anti-Monopoly Law, and discussions are expected to continue.

Product-Related Litigation

U.S. Cell Phone Litigation

Microsoft Mobile Oy, a subsidiary of Microsoft, along with other handset manufacturers and network operators, is a defendant in 40 lawsuits filed in the Superior Court for the District of Columbia by individual plaintiffs who allege that radio emissions from cellular handsets caused their brain tumors and other adverse health effects. We assumed responsibility for these claims in our agreement to acquire Nokia’s Devices and Services business and have been substituted for the Nokia defendants. Nine of these cases were filed in 2002 and are consolidated for certain pre-trial proceedings; the remaining cases are stayed. In a separate 2009 decision, the Court of Appeals for the District of Columbia held that adverse health effect claims arising from the use of cellular handsets that operate within the U.S. Federal Communications Commission radio frequency emission guidelines (“FCC Guidelines”) are pre-empted by federal law. The plaintiffs allege that their handsets either operated outside the FCC Guidelines or were manufactured before the FCC Guidelines went into effect. The lawsuits also allege an industry-wide conspiracy to manipulate the science and testing around emission guidelines.

In 2013, the defendants in the consolidated cases moved to exclude the plaintiffs’ expert evidence of general causation on the basis of flawed scientific methodologies. In 2014, the trial court granted in part and denied in part the defendants’ motion to exclude the plaintiffs’ general causation experts. The defendants filed an interlocutory appeal to the District of Columbia Court of Appeals challenging the standard for evaluating expert scientific evidence. In October 2016, the Court of Appeals issued its decision adopting the standard advocated by the defendants and remanding the cases to the trial court for further proceedings under that standard. The plaintiffs have filed supplemental expert evidence, portions of which the defendants have moved to strike. In August 2018, the trial court issued an order striking portions of the plaintiffs’ expert reports. A hearing on general causation is scheduled for July 2021.

23


PART I

Item 1

 

Other Contingencies

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

As of September 30, 2020, we accrued aggregate legal liabilities of $311 million. While we intend to defend these matters vigorously, adverse outcomes that we estimate could reach approximately $500 million in aggregate beyond recorded amounts are reasonably possible. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact in our consolidated financial statements for the period in which the effects become reasonably estimable.

 

NOTE 15  STOCKHOLDERS’ EQUITY

Share Repurchases

On September 20, 2016, our Board of Directors approved a share repurchase program authorizing up to $40.0 billion in share repurchases. This share repurchase program commenced in December 2016 and was completed in February 2020.

On September 18, 2019, our Board of Directors approved a share repurchase program authorizing up to $40.0 billion in share repurchases. This share repurchase program commenced in February 2020, following completion of the program approved on September 20, 2016, has no expiration date, and may be terminated at any time. As of September 30, 2020, $26.4 billion remained of this $40.0 billion share repurchase program.

We repurchased the following shares of common stock under the share repurchase program:

 

(In millions)

 

Shares

 

Amount

 

 

Shares

 

Amount

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fiscal Year

 

 

 

 

2021

 

 

 

 

 

2020

 

 

 

 

 

 

First Quarter

 

 

25

 

 

$

5,270

 

 

 

29

 

 

$

4,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Shares repurchased during the first quarter of fiscal year 2021 were under the share repurchase program approved on September 18, 2019. Shares repurchased during the first quarter of fiscal year 2020 were under the share repurchase program approved on September 20, 2016. The above table excludes shares repurchased to settle employee tax withholding related to the vesting of stock awards of $1.5 billion and $967 million for the first quarter of fiscal years 2021 and 2020, respectively. All repurchases were made using cash resources.

Dividends

Our Board of Directors declared the following dividends:

 

Declaration Date

 

 

Record Date

 

 

Payment Date

 

 

Dividend

Per Share

 

 

Amount

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fiscal Year 2021

 

 

 

 

 

 

 

 

 

 

 

(In millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

September 15, 2020

 

 

November 19, 2020

 

 

December 10, 2020

 

 

$

0.56

 

 

$

4,236

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fiscal Year 2020

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

September 18, 2019

 

 

November 21, 2019

 

 

December 12, 2019

 

 

$

0.51

 

 

$

3,886

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The dividend declared on September 15, 2020 was included in other current liabilities as of September 30, 2020.

 

24


PART I

Item 1

 

NOTE 16 — ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

The following table summarizes the changes in accumulated other comprehensive income (loss) by component:

 

(In millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

 

2020

 

 

 

2019

 

 

 

 

 

 

 

 

 

 

Derivatives

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, beginning of period

 

$

(38

)

 

$

0

 

Unrealized gains (losses), net of tax of $5 and $(2)

 

 

20

 

 

 

(6

)

 

 

 

 

 

 

 

 

 

Reclassification adjustments for (gains) losses included in earnings

 

 

(20

)

 

 

5

 

Tax expense (benefit) included in provision for income taxes

 

 

4

 

 

 

(1

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amounts reclassified from accumulated other comprehensive income (loss)

 

 

(16

)

 

 

4

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net change related to derivatives, net of tax of $1 and $(1)

 

 

4

 

 

 

(2

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, end of period

 

$

(34

)

 

$

(2

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, beginning of period

 

$

5,478

 

 

$

1,488

 

Unrealized gains (losses), net of tax of $(50) and $156

 

 

(188

)

 

 

576

 

 

 

 

 

 

 

 

 

 

Reclassification adjustments for (gains) losses included in other income (expense), net

 

 

(17

)

 

 

1

 

Tax expense included in provision for income taxes

 

 

4

 

 

 

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amounts reclassified from accumulated other comprehensive income (loss)

 

 

(13

)

 

 

1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net change related to investments, net of tax of $(54) and $156

 

 

(201

)

 

 

577

 

Cumulative effect of accounting changes

 

 

10

 

 

 

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, end of period

 

$

5,287

 

 

$

2,065

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Translation Adjustments and Other

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, beginning of period

 

$

(2,254

)

 

$

(1,828

)

Translation adjustments and other, net of tax of $(9) and $(8)

 

 

111

 

 

 

(296

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, end of period

 

$

(2,143

)

 

$

(2,124

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated other comprehensive income (loss), end of period

 

$

3,110

 

 

$

(61

)

 

 

 

 

 

 

 

 

 

 

NOTE 17  SEGMENT INFORMATION AND GEOGRAPHIC DATA

In its operation of the business, management, including our chief operating decision maker, who is also our Chief Executive Officer, reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with GAAP. During the periods presented, we reported our financial performance based on the following segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing.

Our reportable segments are described below.

Productivity and Business Processes

Our Productivity and Business Processes segment consists of products and services in our portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment primarily comprises:

 

Office Commercial, including Office 365 subscriptions, the Office 365 portion of Microsoft 365 Commercial subscriptions, and Office licensed on-premises, comprising Office, Exchange, SharePoint, Microsoft Teams, Office 365 Security and Compliance, and Skype for Business, and related Client Access Licenses (“CALs”).

25


PART I

Item 1

 

 

Office Consumer, including Microsoft 365 Consumer subscriptions and Office licensed on-premises, and Office Consumer Services, including Skype, Outlook.com, and OneDrive.

 

LinkedIn, including Talent Solutions, Learning Solutions, Marketing Solutions, Sales Solutions, and Premium Subscriptions.

 

Dynamics business solutions, including Dynamics 365, a set of cloud-based applications across ERP and CRM, Dynamics ERP on-premises, and Dynamics CRM on-premises.

Intelligent Cloud

Our Intelligent Cloud segment consists of our public, private, and hybrid server products and cloud services that can power modern business and developers. This segment primarily comprises:

 

Server products and cloud services, including Azure; SQL Server, Windows Server, Visual Studio, System Center, and related CALs; and GitHub.

 

Enterprise Services, including Premier Support Services and Microsoft Consulting Services.

More Personal Computing

Our More Personal Computing segment consists of products and services that put customers at the center of the experience with our technology. This segment primarily comprises:

 

Windows, including Windows OEM licensing and other non-volume licensing of the Windows operating system; Windows Commercial, comprising volume licensing of the Windows operating system, Windows cloud services, and other Windows commercial offerings; patent licensing; Windows Internet of Things; and MSN advertising.

 

Devices, including Surface and PC accessories.

 

Gaming, including Xbox hardware and Xbox content and services, comprising Xbox Live (transactions, Xbox Game Pass and other subscriptions, cloud services, and advertising), video games, and third-party video game royalties.

 

Search.

Revenue and costs are generally directly attributed to our segments. However, due to the integrated structure of our business, certain revenue recognized and costs incurred by one segment may benefit other segments. Revenue from certain contracts is allocated among the segments based on the relative value of the underlying products and services, which can include allocation based on actual prices charged, prices when sold separately, or estimated costs plus a profit margin. Cost of revenue is allocated in certain cases based on a relative revenue methodology. Operating expenses that are allocated primarily include those relating to marketing of products and services from which multiple segments benefit and are generally allocated based on relative gross margin.

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: legal, including settlements and fines; information technology; human resources; finance; excise taxes; field selling; 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 corporate-level activity is not allocated to our segments.

26


PART I

Item 1

 

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

 

(In millions)

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

2020

 

 

2019

 

 

 

 

 

 

 

 

Revenue

 

 

 

 

 

 

 

 

 

 

 

 

 

Productivity and Business Processes

 

$

12,319

 

 

$

11,077

 

Intelligent Cloud

 

 

12,986

 

 

 

10,845

 

More Personal Computing

 

 

11,849

 

 

 

11,133

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

37,154

 

 

$

33,055

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating Income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Productivity and Business Processes

 

$

5,706

 

 

$

4,782

 

Intelligent Cloud

 

 

5,422

 

 

 

3,889

 

More Personal Computing

 

 

4,748

 

 

 

4,015

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

15,876

 

 

$

12,686

 

 

 

 

 

 

 

 

 

 

 

No sales to an individual customer or country other than the United States accounted for more than 10% of revenue for the three months ended September 30, 2020 or 2019. Revenue, classified by the major geographic areas in which our customers were located, was as follows:

 

(In millions)

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

2020

 

 

2019

 

 

 

 

 

United States (a)

 

$

19,025

 

 

$

17,270

 

Other countries

 

 

18,129

 

 

 

15,785

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

37,154

 

 

$

33,055

 

 

 

 

 

 

 

 

 

 

 

(a)

Includes billings to OEMs and certain multinational organizations because of the nature of these businesses and the impracticability of determining the geographic source of the revenue.

Revenue from external customers, classified by significant product and service offerings, was as follows:

 

(In millions)

 

 

 

 

 

 

 

Three Months Ended September 30,

 

2020

 

 

2019

 

 

 

 

 

Server products and cloud services

 

$

11,195

 

 

$

9,192

 

Office products and cloud services

 

 

9,278

 

 

 

8,466

 

Windows

 

 

5,305

 

 

 

5,353

 

Gaming

 

 

3,092

 

 

 

2,542

 

LinkedIn

 

 

2,206

 

 

 

1,909

 

Search advertising

 

 

1,789

 

 

 

1,991

 

Enterprise Services

 

 

1,637

 

 

 

1,545

 

Devices

 

 

1,620

 

 

 

1,202

 

Other

 

 

1,032

 

 

 

855

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

37,154

 

 

$

33,055

 

 

 

 

 

 

 

 

 

 

 

Our commercial cloud revenue, which includes Office 365 Commercial, Azure, the commercial portion of LinkedIn, Dynamics 365, and other commercial cloud properties, was $15.2 billion and $11.6 billion for the three months ended September 30, 2020 and 2019, respectively. These amounts are primarily included in Office products and cloud services, Server products and cloud services, and LinkedIn in the table above.

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. 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.

 

27


PART I

Item 1

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Stockholders and the Board of Directors of Microsoft Corporation

Results of Review of Interim Financial Information

We have reviewed the accompanying consolidated balance sheet of Microsoft Corporation and subsidiaries (the "Company") as of September 30, 2020, the related consolidated statements of income, comprehensive income, cash flows, and stockholders’ equity for the three-month periods ended September 30, 2020 and 2019, and the related notes (collectively referred to as the “interim financial information”). Based on our reviews, we are not aware of any material modifications that should be made to the accompanying interim financial information for it 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) (PCAOB), the consolidated balance sheet of the Company as of June 30, 2020, and the related consolidated statements of income, comprehensive income, cash flows, and stockholders’ equity for the year then ended (not presented herein); and in our report dated July 30, 2020, 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, 2020, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

Basis for Review Results

This interim financial information is the responsibility of the Company's management. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our reviews in accordance with standards of the PCAOB. 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 PCAOB, 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.

 

/S/ DELOITTE & TOUCHE LLP

 

Seattle, Washington

October 27, 2020

 

 

28


PART I

Item 2

 

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

Note About Forward-Looking Statements

This report includes estimates, projections, statements relating to our business plans, objectives, and expected operating results that 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 the following sections: “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Risk Factors” (Part II, Item 1A of this Form 10-Q). 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 that may cause actual results to differ materially. We describe risks and uncertainties that could cause actual results and events to differ materially in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Quantitative and Qualitative Disclosures about Market Risk” (Part I, Item 3 of this Form 10-Q), and “Risk Factors”. We undertake no obligation to update or revise publicly any forward-looking statements, whether because of new information, future events, or otherwise.

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“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, 2020, and our financial statements and the accompanying Notes to Financial Statements (Part I, Item 1 of this Form 10-Q).

OVERVIEW

Microsoft is a technology company whose mission is to empower every person and every organization on the planet to achieve more. We strive to create local opportunity, growth, and impact in every country around the world. Our platforms and tools help drive small business productivity, large business competitiveness, and public-sector efficiency. They also support new startups, improve educational and health outcomes, and empower human ingenuity.

We generate revenue by offering a wide range of cloud-based and other services to people and businesses; licensing and supporting an array of software products; designing, manufacturing, and selling devices; and 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; datacenter costs in support of our cloud-based services; and income taxes.

As the world responds to the outbreak of a novel strain of the coronavirus (“COVID-19”), we are working to do our part by ensuring the safety of our employees, striving to protect the health and well-being of the communities in which we operate, and providing technology and resources to our customers to help them do their best work while remote.

Highlights from the first quarter of fiscal year 2021 compared with the first quarter of fiscal year 2020 included:

 

Commercial cloud revenue increased 31% to $15.2 billion.

 

Office Commercial products and cloud services revenue increased 9%, driven by Office 365 Commercial growth of 21%.

 

Office Consumer products and cloud services revenue increased 13%, with continued growth in Microsoft 365 Consumer subscribers to 45.3 million.

 

LinkedIn revenue increased 16%.

 

Dynamics products and cloud services revenue increased 19%, driven by Dynamics 365 growth of 38%.

 

Server products and cloud services revenue increased 22%, driven by Azure growth of 48%.

 

Windows original equipment manufacturer licensing (“Windows OEM”) revenue decreased 5%.

 

Windows Commercial products and cloud services revenue increased 13%.

 

Xbox content and services revenue increased 30%.

29


PART I

Item 2

 

 

Surface revenue increased 37%.

 

Search advertising revenue, excluding traffic acquisition costs, decreased 10%.

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 identify and address the changing demands of customers and users, industry trends, and competitive forces.

Economic Conditions, Challenges, and Risks

The markets for software, devices, and cloud-based services are dynamic and highly competitive. Our competitors are developing new software and devices, while also deploying competing cloud-based services for consumers and businesses. The devices and form factors customers prefer evolve rapidly, and influence how users access services in the cloud, and in some cases, the user’s choice of which suite of cloud-based services to use. We must continue to evolve and adapt over an extended time in pace with this changing environment. The investments we are making in infrastructure and devices will continue to increase our operating costs and may decrease our operating margins.

Our success is highly dependent on our ability to attract and retain qualified employees. We hire a mix of university and industry talent worldwide. We compete for talented individuals globally by offering an exceptional working environment, broad customer reach, scale in resources, the ability to grow one’s career across many different products and businesses, and competitive compensation and benefits. Aggregate demand for our software, services, and devices is correlated to global macroeconomic and geopolitical factors, which remain dynamic.

Our international operations provide a significant portion of our total revenue and expenses. Many of these revenue and expenses are denominated in currencies other than the U.S. dollar. As a result, changes in foreign exchange rates may significantly affect revenue and expenses. Weakening of the U.S. dollar relative to certain foreign currencies did not have a material impact on reported revenue and expenses from our international operations in the first quarter of fiscal year 2021.

Refer to Risk Factors (Part II, Item 1A of this Form 10-Q) for a discussion of these factors and other risks.

COVID-19

In the first quarter of fiscal year 2021, the COVID-19 pandemic continued to impact our business operations and financial results. In the Productivity and Business Processes and Intelligent Cloud segments, cloud usage and demand benefited as customers work and learn from home. In the More Personal Computing segment, Surface and Gaming benefited from demand to support remote work-, learn-, and play-from-home scenarios, while Search was negatively impacted by reduced customer advertising spend. We continued to experience weakness in transactional licensing across each of our segments as well as a reduction in operating expenses related to remote work. The COVID-19 pandemic may continue to impact our business operations and financial operating results, and there is uncertainty in the nature and degree of its continued effects over time. Refer to Risk Factors (Part II, Item 1A of this Form 10-Q) for further discussion.

Seasonality

Our revenue fluctuates quarterly and is generally higher in the second and fourth quarters of our fiscal year. Second quarter revenue is driven by corporate year-end spending trends in our major markets and holiday season spending by consumers, and fourth quarter revenue is driven by the volume of multi-year on-premises contracts executed during the period.

30


PART I

Item 2

 

Change in Accounting Estimate

In July 2020, we completed an assessment of the useful lives of our server and network equipment and determined we should increase the estimated useful life of server equipment from three years to four years and increase the estimated useful life of network equipment from two years to four years. This change in accounting estimate was effective beginning fiscal year 2021. Based on the carrying amount of server and network equipment included in property and equipment, net as of June 30, 2020, the effect of this change in estimate for the three months ended September 30, 2020, was an increase in operating income of $927 million and net income of $763 million, or $0.10 per both basic and diluted share. It is estimated this change will increase our fiscal year 2021 annual operating income by $2.7 billion.

Reportable Segments

We report our financial performance based on the following segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. The segment amounts included in MD&A are presented on a basis consistent with our internal management reporting. All differences between our internal management reporting basis and accounting principles generally accepted in the United States of America (“GAAP”), along with certain corporate-level and other activity, are included in Corporate and Other.

Additional information on our reportable segments is contained in Note 17 – Segment Information and Geographic Data of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q).

Metrics

We use metrics in assessing the performance of our business and to make informed decisions regarding the allocation of resources. We disclose metrics to enable investors to evaluate progress against our ambitions, provide transparency into performance trends, and reflect the continued evolution of our products and services. Our commercial and other business metrics are fundamentally connected based on how customers use our products and services. The metrics are disclosed in the MD&A or the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q). Financial metrics are calculated based on GAAP results and growth comparisons relate to the corresponding period of last fiscal year.

Commercial

Our commercial business primarily consists of Server products and cloud services, Office Commercial, Windows Commercial, the commercial portion of LinkedIn, Enterprise Services, and Dynamics. Our commercial metrics allow management and investors to assess the overall health of our commercial business and include leading indicators of future performance.

 

Commercial remaining performance obligation

 

Commercial portion of revenue allocated to remaining performance obligations, which includes unearned revenue and amounts that will be invoiced and recognized as revenue in future periods

 

 

 

Commercial cloud revenue

 

Revenue from our commercial cloud business, which includes Office 365 Commercial, Azure, the commercial portion of LinkedIn, Dynamics 365, and other commercial cloud properties

 

 

 

Commercial cloud gross margin percentage

 

Gross margin percentage for our commercial cloud business

 

31


PART I

Item 2

 

Productivity and Business Processes and Intelligent Cloud

Metrics related to our Productivity and Business Processes and Intelligent Cloud segments assess the health of our core businesses within these segments. The metrics reflect our cloud and on-premises product strategies and trends.

 

Office Commercial products and cloud services revenue growth

 

Revenue from Office Commercial products and cloud services, including Office 365 subscriptions, the Office 365 portion of Microsoft 365 Commercial subscriptions, and Office licensed on-premises, comprising Office, Exchange, SharePoint, Microsoft Teams, Office 365 Security and Compliance, and Skype for Business, and related Client Access Licenses (“CALs”)

 

 

 

Office Consumer products and cloud services revenue growth

 

Revenue from Office Consumer products and cloud services, including Microsoft 365 Consumer subscriptions and Office licensed on-premises

 

 

 

Office 365 Commercial seat growth

 

The number of Office 365 Commercial seats at end of period where seats are paid users covered by an Office 365 Commercial subscription

 

 

 

Microsoft 365 Consumer subscribers

 

The number of Microsoft 365 Consumer (formerly Office 365 Consumer) subscribers at end of period

 

 

 

Dynamics products and cloud services revenue growth

 

Revenue from Dynamics products and cloud services, including Dynamics 365, a set of cloud-based applications across ERP and CRM, Dynamics ERP on-premises, and Dynamics CRM on-premises

 

 

 

LinkedIn revenue growth

 

Revenue from LinkedIn, including Talent Solutions, Learning Solutions, Marketing Solutions, Sales Solutions, and Premium Subscriptions

 

 

 

Server products and cloud services revenue growth

 

Revenue from Server products and cloud services, including Azure; SQL Server, Windows Server, Visual Studio, System Center, and related CALs; and GitHub

 

More Personal Computing

Metrics related to our More Personal Computing segment assess the performance of key lines of business within this segment. These metrics provide strategic product insights which allow us to assess the performance across our commercial and consumer businesses. As we have diversity of target audiences and sales motions within the Windows business, we monitor metrics that are reflective of those varying motions.

 

Windows OEM Pro revenue growth

 

Revenue from sales of Windows Pro licenses sold through the OEM channel, which primarily addresses demand in the commercial market

 

 

 

Windows OEM non-Pro revenue growth

 

Revenue from sales of Windows non-Pro licenses sold through the OEM channel, which primarily addresses demand in the consumer market

 

 

 

Windows Commercial products and cloud services revenue growth

 

Revenue from Windows Commercial products and cloud services, comprising volume licensing of the Windows operating system, Windows cloud services, and other Windows commercial offerings

 

 

 

Surface revenue

 

Revenue from Surface devices and accessories

 

 

 

Xbox content and services revenue growth

 

Revenue from Xbox content and services, comprising Xbox Live (transactions, Xbox Game Pass and other subscriptions, cloud services, and advertising), video games, and third-party video game royalties

 

 

 

Search advertising revenue, excluding TAC, growth

 

Revenue from search advertising excluding traffic acquisition costs (“TAC”) paid to Bing Ads network publishers

 

32


PART I

Item 2

 

SUMMARY RESULTS OF OPERATIONS

 

(In millions, except percentages and per share amounts)

 

 

Three Months Ended

September 30,

 

 

Percentage

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2020

 

 

 

2019

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

37,154

 

 

$

33,055

 

 

 

12%

 

Gross margin

 

 

26,152

 

 

 

22,649

 

 

 

15%

 

Operating income

 

 

15,876

 

 

 

12,686

 

 

 

25%

 

Net income

 

 

13,893

 

 

 

10,678

 

 

 

30%

 

Diluted earnings per share

 

 

1.82

 

 

 

1.38

 

 

 

32%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30, 2020 Compared with Three Months Ended September 30, 2019

Revenue increased $4.1 billion or 12%, driven by growth across each of our segments. Intelligent Cloud revenue increased, driven by server products and cloud services. Productivity and Business Processes revenue increased, driven by Office Commercial and LinkedIn. More Personal Computing revenue increased, driven by Gaming and Surface, offset in part by a reduction in Search advertising.

Gross margin increased $3.5 billion or 15%, driven by growth across each of our segments and a reduction in depreciation expense due to the change in estimated useful lives of our server and network equipment. Gross margin percentage increased, driven by the change in estimated useful lives of our server and network equipment. Commercial cloud gross margin percentage increased 5 points to 71%, driven by the change in estimated useful lives of our server and network equipment. Excluding this impact, gross margin percentage increased slightly, driven by gross margin percentage improvement in Azure, offset in part by sales mix shift to Azure.

Operating income increased $3.2 billion or 25%, driven by growth across each of our segments and the change in estimated useful lives of our server and network equipment.

Key changes in expenses were:

 

Cost of revenue increased $596 million or 6%, primarily driven by growth in commercial cloud, offset in part by the change in estimated useful lives of our server and network equipment.

 

Research and development expenses increased $361 million or 8%, driven by investments in cloud engineering.

 

Sales and marketing expenses decreased $106 million or 2%, primarily driven by reductions in advertising, offset in part by investments in commercial sales.

 

General and administrative expenses increased $58 million or 5%, driven by an increase in business taxes.

SEGMENT RESULTS OF OPERATIONS

 

(In millions, except percentages)

 

Three Months Ended

September 30,

 

 

Percentage

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2020

 

 

2019

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Productivity and Business Processes

 

$

12,319

 

 

$

11,077

 

 

 

11%

 

Intelligent Cloud

 

 

12,986

 

 

 

10,845

 

 

 

20%

 

More Personal Computing

 

 

11,849

 

 

 

11,133

 

 

 

6%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

37,154

 

 

$

33,055

 

 

 

12%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating Income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Productivity and Business Processes

 

$

5,706

 

 

$

4,782

 

 

 

19%

 

Intelligent Cloud

 

 

5,422

 

 

 

3,889

 

 

 

39%

 

More Personal Computing

 

 

4,748

 

 

 

4,015

 

 

 

18%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

15,876

 

 

$

12,686

 

 

 

25%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

33


PART I

Item 2

 

Reportable Segments

Three Months Ended September 30, 2020 Compared with Three Months Ended September 30, 2019

Productivity and Business Processes

Revenue increased $1.2 billion or 11%.

 

Office Commercial products and cloud services revenue increased $672 million or 9%, on a strong prior year comparable that benefited from transactional strength, primarily in Japan. Office 365 Commercial revenue grew 21%, due to seat growth of 15% and higher revenue per user. Office Commercial products revenue declined 30%, reflecting continued customer shift to cloud offerings from multi-year on-premises agreements and continued transactional weakness, as well as the impact from a strong prior year comparable.

 

Office Consumer products and cloud services revenue increased $140 million or 13%, driven by Microsoft 365 Consumer subscription revenue. Microsoft 365 Consumer subscribers increased 27% to 45.3 million.

 

LinkedIn revenue increased $297 million or 16%, driven by growth in Marketing Solutions.

 

Dynamics products and cloud services revenue increased 19%, driven by Dynamics 365 growth of 38%.

Operating income increased $924 million or 19%.

 

Gross margin increased $1.1 billion or 13%, driven by growth in LinkedIn and Office Commercial, and the change in estimated useful lives of our server and network equipment. Gross margin percentage increased slightly with the change in estimated useful lives of our server and network equipment. Excluding this impact, gross margin percentage decreased, driven by increased usage of Office 365 Commercial and an increased mix of cloud offerings.

 

Operating expenses increased $155 million or 4%, driven by investments in cloud engineering and Teams marketing.

Intelligent Cloud

Revenue increased $2.1 billion or 20%.

 

Server products and cloud services revenue increased $2.0 billion or 22%, driven by Azure. Azure revenue grew 48%, due to growth in our consumption-based services. Server products revenue decreased 1% on a strong prior year comparable, with continued weakness in transactional licensing.

 

Enterprise Services revenue increased $92 million or 6%, driven by growth in Premier Support Services.

Operating income increased $1.5 billion or 39%.

 

Gross margin increased $1.9 billion or 26%, driven by growth in server products and cloud services and the change in estimated useful lives of our server and network equipment. Gross margin percentage increased with the change in estimated useful lives of our server and network equipment. Excluding this impact, gross margin percentage decreased slightly, driven by sales mix shift to Azure, offset in part by gross margin percentage improvement in Azure.

 

Operating expenses increased $369 million or 10%, driven by investments in Azure.

More Personal Computing

Revenue increased $716 million or 6%.

 

Windows revenue decreased $48 million or 1%, primarily driven by a decrease in Windows OEM, offset in part by growth in Windows Commercial. Windows OEM revenue decreased 5%. Windows OEM Pro revenue decreased 22%, impacted by lower commercial demand and a strong prior year comparable. Windows OEM non-Pro revenue grew 31%, driven by consumer PC demand. Windows Commercial products and cloud services revenue increased 13%, driven by increased demand for Microsoft 365, offset in part by a decrease in agreements that carry higher in-quarter revenue recognition and continued weakness in transactional licensing.

34


PART I

Item 2

 

 

Gaming revenue increased $550 million or 22%, driven by an increase in Xbox content and services, offset in part by a decrease in Xbox hardware. Xbox content and services revenue increased $649 million or 30%, driven by growth in third-party titles, Xbox Game Pass subscriptions, and first-party titles. Xbox hardware revenue declined 27%, driven by a decrease in volume of consoles sold ahead of new console launches.

 

Surface revenue increased $417 million or 37%, driven by year-over-year differences in product launch timing and channel purchasing, as well as PC market demand.

 

Search advertising revenue decreased $202 million or 10%. Search advertising revenue, excluding traffic acquisition costs, decreased 10%, driven by reduced customer advertising spend.

Operating income increased $733 million or 18%.

 

Gross margin increased $522 million or 8%, driven by growth in Gaming and Surface. Gross margin percentage increased slightly, primarily driven by gross margin percentage improvement in Gaming and Surface, offset in part by a lower sales mix of Windows.

 

Operating expenses decreased $211 million or 8%, primarily driven by reductions in advertising.

OPERATING EXPENSES

Research and Development

 

(In millions, except percentages)

 

Three Months Ended

September 30,

 

Percentage
Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2020

 

 

2019

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Research and development

 

$

4,926

 

 

$

4,565

 

 

8%

 

As a percent of revenue

 

 

13%

 

 

 

14%

 

 

(1)ppt

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content.

Three Months Ended September 30, 2020 Compared with Three Months Ended September 30, 2019

Research and development expenses increased $361 million or 8%, driven by investments in cloud engineering.

Sales and Marketing

 

(In millions, except percentages)

 

Three Months Ended

September 30,

 

Percentage

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2020

 

 

2019

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales and marketing

 

$

4,231

 

 

$

4,337

 

 

 

(2)%

 

As a percent of revenue

 

 

11%

 

 

 

13%

 

 

 

(2)ppt

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs.

Three Months Ended September 30, 2020 Compared with Three Months Ended September 30, 2019

Sales and marketing expenses decreased $106 million or 2%, primarily driven by reductions in advertising, offset in part by investments in commercial sales.

35


PART I

Item 2

 

General and Administrative

 

(In millions, except percentages)

 

Three Months Ended

September 30,

 

Percentage

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2020

 

 

2019

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

General and administrative

 

$

1,119

 

 

$

1,061

 

 

5%

 

As a percent of revenue

 

 

3%

 

 

 

3%

 

 

0ppt

 

 

 

 

 

 

 

 

 

 

 

 

 

 

General and administrative expenses include payroll, employee benefits, stock-based compensation expense, severance expense, and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative personnel, certain taxes, and legal and other administrative fees.

Three Months Ended September 30, 2020 Compared with Three Months Ended September 30, 2019

General and administrative expenses increased $58 million or 5%, driven by an increase in business taxes.

OTHER INCOME (EXPENSE), NET

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

 

(In millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

2020

 

 

2019

 

 

 

 

 

 

 

 

 

 

Interest and dividends income

 

$

570

 

 

$

724

 

Interest expense

 

 

(589

)

 

 

(637

)

Net recognized gains (losses) on investments

 

 

125

 

 

 

(57

)

Net gains on derivatives

 

 

3

 

 

 

46

 

Net gains (losses) on foreign currency remeasurements

 

 

139

 

 

 

(58

)

Other, net

 

 

0

 

 

 

(18

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

248

 

 

$

0

 

 

 

 

 

 

 

 

 

 

 

We use derivative instruments to: manage risks related to foreign currencies, equity prices, interest rates, and credit; enhance investment returns; and facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedging instruments are primarily recognized in other income (expense), net.

Three Months Ended September 30, 2020 Compared with Three Months Ended September 30, 2019

Interest and dividends income decreased due to lower yields, offset in part by higher average portfolio balances on fixed-income securities. Interest expense decreased due to a decrease in outstanding long-term debt due to debt maturities and higher capitalization of interest expense, offset in part by higher finance lease expense. Net recognized gains on investments increased due to gains on equity securities in the current period compared to losses in the prior period. Net gains on derivatives decreased due to lower gains on foreign exchange derivatives.

INCOME TAXES

Effective Tax Rate

Our effective tax rate was 14% and 16% for the three months ended September 30, 2020 and 2019, respectively. The decrease in our effective tax rate for the current quarter compared to the prior year was primarily due to an increase in tax benefits relating to stock-based compensation.

Our effective tax rate was lower than the U.S. federal statutory rate for the three months ended September 30, 2020, 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 and Puerto Rico, and tax benefits relating to stock-based compensation.

36


PART I

Item 2

 

Uncertain Tax Positions

We settled a portion of the Internal Revenue Service (“IRS”) audit for tax years 2004 to 2006 in fiscal year 2011. In February 2012, the IRS withdrew its 2011 Revenue Agents Report related to unresolved issues for tax years 2004 to 2006 and reopened the audit phase of the examination. We also settled a portion of the IRS audit for tax years 2007 to 2009 in fiscal year 2016, and a portion of the IRS audit for tax years 2010 to 2013 in fiscal year 2018. We remain under audit for tax years 2004 to 2017.

As of September 30, 2020, the primary unresolved issues for the IRS audits relate to transfer pricing, which could have a material impact in our consolidated financial statements when the matters are resolved. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved key transfer pricing issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months.

We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2020, some of which are currently under audit by local tax authorities. The resolution of each of these audits is not expected to be material to our consolidated financial statements.

FINANCIAL CONDITION

Cash, Cash Equivalents, and Investments

Cash, cash equivalents, and short-term investments totaled $138.0 billion and $136.5 billion as of September 30, 2020 and June 30, 2020. Equity investments were $3.1 billion and $3.0 billion as of September 30, 2020 and June 30, 2020, respectively. Our short-term investments are primarily intended to facilitate liquidity and capital preservation. They consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantly U.S. dollar-denominated securities, but also include foreign currency-denominated securities to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are managed to achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid investment-grade fixed-income securities.

Valuation

In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our financial instruments. This pricing methodology applies to our Level 1 investments, such as U.S. government securities, common and preferred stock, and mutual funds. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments, such as commercial paper, certificates of deposit, U.S. agency securities, foreign government bonds, mortgage- and asset-backed securities, corporate notes and bonds, and municipal securities. Level 3 investments are valued using internally-developed models with unobservable inputs. Assets and liabilities measured at fair value on a recurring basis using unobservable inputs are an immaterial portion of our portfolio.

A majority of our investments are priced by pricing vendors and are generally Level 1 or Level 2 investments as these vendors either provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted price is not available, the investment is not priced by our pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally classified as Level 2 investments because the broker prices these investments based on similar assets without applying significant adjustments. In addition, all our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these investments. Our fair value processes include controls that are designed to ensure appropriate fair values are recorded. These controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and independent recalculation of prices where appropriate.

37


PART I

Item 2

 

Cash Flows

Three Months Ended September 30, 2020 Compared with Three Months Ended September 30, 2019

Cash from operations increased $5.5 billion to $19.3 billion for the three months ended September 30, 2020, mainly due to an increase in cash received from customers and a decrease in cash used to pay income taxes, offset in part by an increase in cash paid to suppliers and employees. Cash used in financing increased $80 million to $10.3 billion for the three months ended September 30, 2020, mainly due to a $1.8 billion increase in common stock repurchases and a $346 million increase in dividends paid, offset in part by a $2.5 billion decrease in repayments of debt. Cash used in investing increased $3.6 billion to $5.4 billion for the three months ended September 30, 2020, mainly due to $2.1 billion in other investing to facilitate the purchase of components and a $1.5 billion increase in additions to property and equipment.

Debt

We issue debt to take advantage of favorable pricing and liquidity in the debt markets, reflecting our credit rating and the low interest rate environment. The proceeds of these issuances were or will be used for general corporate purposes, which may include, among other things, funding for working capital, capital expenditures, repurchases of capital stock, acquisitions, and repayment of existing debt. In June 2020, we exchanged a portion of our existing debt at premium for cash and new debt with longer maturities to take advantage of favorable financing rates in the debt markets, reflecting our credit rating and the low interest rate environment. Refer to Note 10 – Debt of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion.

Unearned Revenue

Unearned revenue comprises mainly unearned revenue related to volume licensing programs, which may include Software Assurance (“SA”) and cloud services. Unearned revenue is generally invoiced annually at the beginning of each contract period for multi-year agreements and recognized ratably over the coverage period. Unearned revenue also includes payments for other offerings for which we have been paid in advance and earn the revenue when we transfer control of the product or service.

The following table outlines the expected future recognition of unearned revenue as of September 30, 2020:

 

(In millions)

 

 

 

 

 

 

 

 

Three Months Ending

 

 

 

 

 

 

December 31, 2020

 

$

15,056

 

March 31, 2021

 

 

10,485

 

June 30, 2021

 

 

6,245

 

September 30, 2021

 

 

1,690

 

Thereafter

 

 

2,829

 

 

 

 

 

Total

 

$

36,305

 

 

 

 

 

 

 

If our customers choose to license cloud-based versions of our products and services rather than licensing transaction-based products and services, the associated revenue will shift from being recognized at the time of the transaction to being recognized over the subscription period or upon consumption, as applicable.

Share Repurchases

For the three months ended September 30, 2020 and 2019, we repurchased 25 million shares and 29 million shares of our common stock for $5.3 billion and $4.0 billion, respectively, through our share repurchase programs. All repurchases were made using cash resources. Refer to Note 15 – Stockholders’ Equity of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion.

Dividends

Refer to Note 15 – Stockholders’ Equity of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion.

38


PART I

Item 2

 

Off-Balance Sheet Arrangements

We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. Additionally, we have agreed to cover damages resulting from breaches of certain security and privacy commitments in our cloud business. In evaluating estimated losses on these obligations, we consider factors such as the degree of probability of an unfavorable outcome and our ability to make a reasonable estimate of the amount of loss. These obligations did not have a material impact in our consolidated financial statements during the periods presented.

Other Planned Uses of Capital

On September 19, 2020, we entered into a definitive agreement to acquire ZeniMax Media Inc., the parent company of Bethesda Softworks LLC, for $7.5 billion in cash. We expect this acquisition to close in the second half of fiscal year 2021, subject to customary closing conditions and completion of regulatory review.

We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology, as well as continue making acquisitions that align with our business strategy. Additions to property and equipment will continue, including new facilities, datacenters, and computer systems for research and development, sales and marketing, support, and administrative staff. We expect capital expenditures to increase in coming years to support growth in our cloud offerings. We have operating and finance leases for datacenters, corporate offices, research and development facilities, retail stores, and certain equipment. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital resources.

Liquidity

As a result of the Tax Cuts and Jobs Act (“TCJA”), we are required to pay a one-time transition tax on deferred foreign income not previously subject to U.S. income tax. Under the TCJA, the transition tax is payable in interest-free installments over eight years, with 8% due in each of the first five years, 15% in year six, 20% in year seven, and 25% in year eight. We have paid transition tax of $4.7 billion, which included $1.5 billion during the three months ended September 30, 2020. The remaining transition tax of $13.7 billion is payable over the next five years with a final payment in fiscal year 2026.

We expect existing cash, cash equivalents, short-term investments, cash flows from operations, and access to capital markets to continue to be sufficient to fund our operating activities and cash commitments for investing and financing activities, such as dividends, share repurchases, debt maturities, material capital expenditures, and the transition tax related to the TCJA, for at least the next 12 months and thereafter for the foreseeable future.

RECENT ACCOUNTING GUIDANCE

Refer to Note 1 – Accounting Policies of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion.

APPLICATION OF CRITICAL ACCOUNTING POLICIES

Our consolidated financial statements and accompanying notes are prepared in accordance with GAAP. Preparing consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies, as well as uncertainty in the current economic environment due to the recent outbreak of COVID-19. Critical accounting policies for us include revenue recognition, impairment of investment securities, goodwill, research and development costs, contingencies, income taxes, and inventories.

39


PART I

Item 2

 

Revenue Recognition

Our contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment. When a cloud-based service includes both on-premises software licenses and cloud services, judgment is required to determine whether the software license is considered distinct and accounted for separately, or not distinct and accounted for together with the cloud service and recognized over time. Certain cloud services, primarily Office 365, depend on a significant level of integration, interdependency, and interrelation between the desktop applications and cloud services, and are accounted for together as one performance obligation. Revenue from Office 365 is recognized ratably over the period in which the cloud services are provided.

Judgment is required to determine the SSP for each distinct performance obligation. We use a single amount to estimate SSP for items that are not sold separately, including on-premises licenses sold with SA or software updates provided at no additional charge. We use a range of amounts to estimate SSP when we sell each of the products and services separately and need to determine whether there is a discount to be allocated based on the relative SSP of the various products and services.

In instances where SSP is not directly observable, such as when we do not sell the product or service separately, we determine the SSP using information that may include market conditions and other observable inputs. We typically have more than one SSP for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, we may use information such as the size of the customer and geographic region in determining the SSP.

 

Due to the various benefits from and the nature of our SA program, judgment is required to assess the pattern of delivery, including the exercise pattern of certain benefits across our portfolio of customers.

Our products are generally sold with a right of return, we may provide other credits or incentives, and in certain instances we estimate customer usage of our products and services, which are accounted for as variable consideration when determining the amount of revenue to recognize. Returns and credits are estimated at contract inception and updated at the end of each reporting period if additional information becomes available. Changes to our estimated variable consideration were not material for the periods presented.

Impairment of Investment Securities

We review debt investments quarterly for credit losses and impairment. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, and the extent to which the fair value is less than cost. This determination requires significant judgment. In making this judgment, we employ a systematic methodology that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. In addition, we consider specific adverse conditions related to the financial health of, and business outlook for, the investee. If we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery, then a decline in fair value below cost is recorded as an impairment charge in other income (expense), net and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments.

Equity investments without readily determinable fair values are written down to fair value if a qualitative assessment indicates that the investment is impaired and the fair value of the investment is less than carrying value. We perform a qualitative assessment on a periodic basis. We are required to estimate the fair value of the investment to determine the amount of the impairment loss. Once an investment is determined to be impaired, an impairment charge is recorded in other income (expense), net.

Goodwill

We allocate goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit.

40


PART I

Item 2

 

Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated primarily through the use of a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital.

The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit.

Research and Development Costs

Costs incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to production. The amortization of these costs is included in cost of revenue over the estimated life of the products.

Legal and Other Contingencies

The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency such as a legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our consolidated financial statements.

Income Taxes

The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year, and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Accounting literature also provides guidance on derecognition of income tax assets and liabilities, classification of deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized in our consolidated financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our consolidated financial statements.

Inventories

Inventories are stated at average cost, subject to the lower of cost or net realizable value. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. Net realizable value is the estimated selling price less estimated costs of completion, disposal, and transportation. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. These reviews include analysis of demand forecasts, product life cycle status, product development plans, current sales levels, pricing strategy, and component cost trends. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue.

 

 

 

41


PART I

Item 3, 4

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

RISKS

We are exposed to economic risk from foreign exchange rates, interest rates, credit risk, and equity prices. We use derivatives instruments to manage these risks, however, they may still impact our consolidated financial statements.

Foreign Currencies

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 positions, including hedges. Principal currency exposures include the Euro, Japanese yen, British pound, Canadian dollar, and Australian dollar.

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 the fixed-income portfolio to achieve economic returns that correlate to certain global fixed-income indices.

Credit

Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We manage credit exposures relative to broad-based indices and to facilitate portfolio diversification.

Equity

Securities held in our equity investments portfolio are subject to price risk.

SENSITIVITY ANALYSIS

The following table sets forth the potential loss in future earnings or fair values, including associated derivatives, resulting from hypothetical changes in relevant market rates or prices:

 

(In millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Risk Categories

 

 

Hypothetical Change

 

September 30,

2020

 

 

Impact

 

 

 

 

 

 

 

 

 

 

 

 

Foreign currency—Revenue

 

 

10% decrease in foreign exchange rates

 

$

(4,748

)

 

Earnings

 

Foreign currency—Investments

 

 

10% decrease in foreign exchange rates

 

 

(104

)

 

Fair Value

 

Interest rate

 

 

100 basis point increase in U.S. treasury interest rates

 

 

(3,843

)

 

Fair Value

 

Credit

 

 

100 basis point increase in credit spreads

 

 

(288

)

 

Fair Value

 

Equity

 

 

10% decrease in equity market prices

 

 

(259

)

 

Earnings

 

 

 

 

 

 

 

 

 

 

 

 

 

ITEM 4. CONTROLS AND PROCEDURES

Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. There were no changes in our internal control over financial reporting during the quarter ended September 30, 2020 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

 

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PART II. OTHER INFORMATION

Refer to Note 14 – Contingencies of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for information regarding legal proceedings in which we are involved.

ITEM 1A. RISK FACTORS

Our operations and financial results are subject to various risks and uncertainties, including those described below, that could adversely affect our business, financial condition, results of operations, cash flows, and the trading price of our common stock.

We face intense competition across all markets for our products and services, which may lead to lower revenue or operating margins.

Competition in the technology sector

Our competitors range in size from diversified global companies with significant research and development resources to small, specialized firms whose narrower product lines may let them be more effective in deploying technical, marketing, and financial resources. Barriers to entry in many of our businesses are low and many of the areas in which we compete evolve rapidly with changing and disruptive technologies, shifting user needs, and frequent introductions of new products and services. Our ability to remain competitive depends on our success in making innovative products, devices, and services that appeal to businesses and consumers.

Competition among platform-based ecosystems

An important element of our business model has been to create platform-based ecosystems on which many participants can build diverse solutions. A well-established ecosystem creates beneficial network effects among users, application developers, and the platform provider that can accelerate growth. Establishing significant scale in the marketplace is necessary to achieve and maintain attractive margins. We face significant competition from firms that provide competing platforms.

 

A competing vertically-integrated model, in which a single firm controls the software and hardware elements of a product and related services, has succeeded with some consumer products such as personal computers, tablets, phones, gaming consoles, wearables, and other endpoint devices. Competitors pursuing this model also earn revenue from services integrated with the hardware and software platform, including applications and content sold through their integrated marketplaces. They may also be able to claim security and performance benefits from their vertically integrated offer. We also offer some vertically-integrated hardware and software products and services. To the extent we shift a portion of our business to a vertically integrated model we increase our cost of revenue and reduce our operating margins.

 

We derive substantial revenue from licenses of Windows operating systems on PCs. We face significant competition from competing platforms developed for new devices and form factors such as smartphones and tablet computers. These devices compete on multiple bases including price and the perceived utility of the device and its platform. Users are increasingly turning to these devices to perform functions that in the past were performed by personal computers. Even if many users view these devices as complementary to a personal computer, the prevalence of these devices may make it more difficult to attract application developers to our PC operating system platforms. Competing with operating systems licensed at low or no cost may decrease our PC operating system margins. Popular products or services offered on competing platforms could increase their competitive strength. In addition, some of our devices compete with products made by our original equipment manufacturer (“OEM”) partners, which may affect their commitment to our platform.

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Competing platforms have content and application marketplaces with scale and significant installed bases. The variety and utility of content and applications available on a platform are important to device purchasing decisions. Users may incur costs to move data and buy new content and applications when switching platforms. To compete, we must successfully enlist developers to write applications for our platform and ensure that these applications have high quality, security, customer appeal, and value. Efforts to compete with competitors’ content and application marketplaces may increase our cost of revenue and lower our operating margins. Competitors’ rules governing their content and applications marketplaces may restrict our ability to distribute products and services through them in accordance with our technical and business model objectives.

Business model competition

Companies compete with us based on a growing variety of business models.

 

Even as we transition more of our business to infrastructure-, platform-, and software-as-a-service business model, the license-based proprietary software model generates a substantial portion of our software revenue. We bear the costs of converting original ideas into software products through investments in research and development, offsetting these costs with the revenue received from licensing our products. Many of our competitors also develop and sell software to businesses and consumers under this model.

 

Other competitors develop and offer free applications, online services and content, and make money by selling third-party advertising. Advertising revenue funds development of products and services these competitors provide to users at no or little cost, competing directly with our revenue-generating products.

 

Some companies compete with us by modifying and then distributing open source software at little or no cost to end users, and earning revenue on advertising or integrated products and services. These firms do not bear the full costs of research and development for the open source software. Some open source software mimics the features and functionality of our products.

The competitive pressures described above may cause decreased sales volumes, price reductions, and/or increased operating costs, such as for research and development, marketing, and sales incentives. This may lead to lower revenue, gross margins, and operating income.

Our increasing focus on cloud-based services presents execution and competitive risks. A growing part of our business involves cloud-based services available across the spectrum of computing devices. Our strategic vision is to compete and grow by building best-in-class platforms and productivity services for an intelligent cloud and an intelligent edge infused with artificial intelligence (“AI”). At the same time, our competitors are rapidly developing and deploying cloud-based services for consumers and business customers. Pricing and delivery models are evolving. Devices and form factors influence how users access services in the cloud and sometimes the user’s choice of which cloud-based services to use. We are devoting significant resources to develop and deploy our cloud-based strategies. The Windows ecosystem must continue to evolve with this changing environment. We embrace cultural and organizational changes to drive accountability and eliminate obstacles to innovation. Our intelligent cloud and intelligent edge worldview is connected with the growth of the Internet of Things (“IoT”). Our success in the IoT will depend on the level of adoption of our offerings such as Azure, Azure Stack, Azure IoT Edge, and Azure Sphere. We may not establish market share sufficient to achieve scale necessary to achieve our business objectives.

Besides software development costs, we are incurring costs to build and maintain infrastructure to support cloud computing services. These costs will reduce the operating margins we have previously achieved. Whether we succeed in cloud-based services depends on our execution in several areas, including:

 

Continuing to bring to market compelling cloud-based experiences that generate increasing traffic and market share.

 

Maintaining the utility, compatibility, and performance of our cloud-based services on the growing array of computing devices, including PCs, smartphones, tablets, gaming consoles, and other devices, as well as sensors and other IoT endpoints.

 

Continuing to enhance the attractiveness of our cloud platforms to third-party developers.

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Ensuring our cloud-based services meet the reliability expectations of our customers and maintain the security of their data as well as help them meet their own compliance needs.

 

Making our suite of cloud-based services platform-agnostic, available on a wide range of devices and ecosystems, including those of our competitors.

It is uncertain whether our strategies will attract the users or generate the revenue required to succeed. If we are not effective in executing organizational and technical changes to increase efficiency and accelerate innovation, or if we fail to generate sufficient usage of our new products and services, we may not grow revenue in line with the infrastructure and development investments described above. This may negatively impact gross margins and operating income.

We make significant investments in products and services that may not achieve expected returns. We will continue to make significant investments in research, development, and marketing for existing products, services, and technologies, including the Windows operating system, Microsoft 365, Office, Bing, SQL Server, Windows Server, Azure, Office 365, Xbox Live, LinkedIn, and other products and services. We also invest in the development and acquisition of a variety of hardware for productivity, communication, and entertainment including PCs, tablets, gaming devices, and HoloLens. Investments in new technology are speculative. Commercial success depends on many factors, including innovativeness, developer support, and effective distribution and marketing. If customers do not perceive our latest offerings as providing significant new functionality or other value, they may reduce their purchases of new software and hardware products or upgrades, unfavorably affecting revenue. We may not achieve significant revenue from new product, service, and distribution channel investments for several years, if at all. New products and services may not be profitable, and even if they are profitable, operating margins for some new products and businesses will not be as high as the margins we have experienced historically. We may not get engagement in certain features, like Edge and Bing, that drive post-sale monetization opportunities. Our data handling practices across our products and services will continue to be under scrutiny and perceptions of mismanagement, driven by regulatory activity or negative public reaction to our practices or product experiences, which could negatively impact product and feature adoption, product design, and product quality.

Developing new technologies is complex. It can require long development and testing periods. Significant delays in new releases or significant problems in creating new products or services could adversely affect our revenue.

Acquisitions, joint ventures, and strategic alliances may have an adverse effect on our business. We expect to continue making acquisitions and entering into joint ventures and strategic alliances as part of our long-term business strategy. For example, in October 2018, we completed our acquisition of GitHub, Inc. (“GitHub”) for $7.5 billion. These acquisitions and other transactions and arrangements involve significant challenges and risks, including that they do not advance our business strategy, that we get an unsatisfactory return on our investment, that we have difficulty integrating and retaining new employees, business systems, and technology, or that they distract management from our other businesses. If an arrangement fails to adequately anticipate changing circumstances and interests of a party, it may result in early termination or renegotiation of the arrangement. The success of these transactions and arrangements will depend in part on our ability to leverage them to enhance our existing products and services or develop compelling new ones. It may take longer than expected to realize the full benefits from these transactions and arrangements such as increased revenue or enhanced efficiencies, or the benefits may ultimately be smaller than we expected. These events could adversely affect our consolidated financial statements.

If our goodwill or amortizable intangible assets become impaired, we may be required to record a significant charge to earnings. We acquire other companies and intangible assets and may not realize all the economic benefit from those acquisitions, which could cause an impairment of goodwill or intangibles. We review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. We test goodwill for impairment at least annually. Factors that may be a change in circumstances, indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable, include a decline in our stock price and market capitalization, reduced future cash flow estimates, and slower growth rates in industry segments in which we participate. We have in the past recorded, and may in the future be required to record, a significant charge in our consolidated financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is determined, negatively affecting our results of operations.

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Cyberattacks and security vulnerabilities could lead to reduced revenue, increased costs, liability claims, or harm to our reputation or competitive position.

Security of our information technology

Threats to IT security can take a variety of forms. Individual and groups of hackers and sophisticated organizations, including state-sponsored organizations or nation-states, continuously undertake attacks that pose threats to our customers and our IT. These actors may use a wide variety of methods, which may include developing and deploying malicious software or exploiting vulnerabilities in hardware, software, or other infrastructure in order to attack our products and services or gain access to our networks and datacenters, using social engineering techniques to induce our employees, users, partners, or customers to disclose passwords or other sensitive information or take other actions to gain access to our data or our users’ or customers’ data, or acting in a coordinated manner to launch distributed denial of service or other coordinated attacks. Inadequate account security practices may also result in unauthorized access to confidential data. For example, system administrators may fail to timely remove employee account access when no longer appropriate. Employees or third parties may intentionally compromise our or our users’ security or systems, or reveal confidential information.

Cyberthreats are constantly evolving, increasing the difficulty of detecting and successfully defending against them. We may have no current capability to detect certain vulnerabilities, which may allow them to persist in the environment over long periods of time. Cyberthreats can have cascading impacts that unfold with increasing speed across our internal networks and systems and those of our partners and customers. Breaches of our facilities, network, or data security could disrupt the security of our systems and business applications, impair our ability to provide services to our customers and protect the privacy of their data, result in product development delays, compromise confidential or technical business information harming our reputation or competitive position, result in theft or misuse of our intellectual property or other assets, require us to allocate more resources to improve technologies, or otherwise adversely affect our business.

In addition, our internal IT environment continues to evolve. Often, we are early adopters of new devices and technologies. We embrace new ways of sharing data and communicating internally and with partners and customers using methods such as social networking and other consumer-oriented technologies. Our business policies and internal security controls may not keep pace with these changes as new threats emerge.

Security of our products, services, devices, and customers’ data

The security of our products and services is important in our customers’ decisions to purchase or use our products or services. Security threats are a significant challenge to companies like us whose business is providing technology products and services to others. Threats to our own IT infrastructure can also affect our customers. Customers using our cloud-based services rely on the security of our infrastructure, including hardware and other elements provided by third parties, to ensure the reliability of our services and the protection of their data. Adversaries tend to focus their efforts on the most popular operating systems, programs, and services, including many of ours, and we expect that to continue. Adversaries that are attacking our customers’ on-premises environments will continue to attack those customers using our cloud services as customers embrace digital transformation. Adversaries that acquire user account information can use that information to compromise our users’ accounts, including where accounts share the same attributes as passwords. Inadequate account security practices may also result in unauthorized access, and user activity may result in ransomware or other malicious software impacting a customer’s use of our products or services. We are increasingly incorporating open source software into our products. There may be vulnerabilities in open source software that may make our products susceptible to cyberattacks.

To defend against security threats to our internal IT systems, our cloud-based services, and our customers’ systems, we must continuously engineer more secure products and services, enhance security and reliability features, improve the deployment of software updates to address security vulnerabilities in our own products as well as those provided by others, develop mitigation technologies that help to secure customers from attacks even when software updates are not deployed, maintain the digital security infrastructure that protects the integrity of our network, products, and services, and provide security tools such as firewalls and anti-virus software and information about the need to deploy security measures and the impact of doing so. Customers in certain industries such as financial services, health care, and government may have enhanced or specialized requirements to which we must engineer our product and services.

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The cost of these steps could reduce our operating margins. If we fail to do these things well, actual or perceived security vulnerabilities in our products and services, data corruption issues, or reduced performance could harm our reputation and lead customers to reduce or delay future purchases of products or subscriptions to services, or to use competing products or services. Customers may also spend more on protecting their existing computer systems from attack, which could delay adoption of additional products or services. Customers, and third parties granted access to their systems, may fail to update their systems, continue to run software or operating systems we no longer support, or may fail timely to install or enable security patches, or may otherwise fail to adopt adequate security practices. Any of these could adversely affect our reputation and revenue. Actual or perceived vulnerabilities may lead to claims against us. Our license agreements typically contain provisions that eliminate or limit our exposure to liability, but there is no assurance these provisions will withstand legal challenges. At times, to achieve commercial objectives, we may enter into agreements with larger liability exposure to customers.

Our products operate in conjunction with and are dependent on products and components across a broad ecosystem of third parties. If there is a security vulnerability in one of these components, and if there is a security exploit targeting it, we could face increased costs, liability claims, reduced revenue, or harm to our reputation or competitive position.

Disclosure and misuse of personal data could result in liability and harm our reputation. As we continue to grow the number and scale of our cloud-based offerings, we store and process increasingly large amounts of personally identifiable information of our customers and users. The continued occurrence of high-profile data breaches provides evidence of an external environment increasingly hostile to information security. Despite our efforts to improve the security controls across our business groups and geographies, it is possible our security controls over personal data, our training of employees and third parties on data security, and other practices we follow may not prevent the improper disclosure or misuse of customer or user data we or our vendors store and manage. In addition, third parties who have limited access to our customer or user data may use this data in unauthorized ways. Improper disclosure or misuse could harm our reputation, lead to legal exposure to customers or users, or subject us to liability under laws that protect personal data, resulting in increased costs or loss of revenue. Our software products and services also enable our customers and users to store and process personal data on-premises or, increasingly, in a cloud-based environment we host. Government authorities can sometimes require us to produce customer or user data in response to valid legal orders. In the U.S. and elsewhere, we advocate for transparency concerning these requests and appropriate limitations on government authority to compel disclosure. Despite our efforts to protect customer and user data, perceptions that the collection, use, and retention of personal information is not satisfactorily protected could inhibit sales of our products or services, and could limit adoption of our cloud-based solutions by consumers, businesses, and government entities. Additional security measures we may take to address customer or user concerns, or constraints on our flexibility to determine where and how to operate datacenters in response to customer or user expectations or governmental rules or actions, may cause higher operating expenses or hinder growth of our products and services.

We may not be able to protect information in our products and services from use by others. LinkedIn and other Microsoft products and services contain valuable information and content protected by contractual restrictions or technical measures. In certain cases, we have made commitments to our members and users to limit access to or use of this information. Changes in the law or interpretations of the law may weaken our ability to prevent third parties from scraping or gathering information or content through use of bots or other measures and using it for their own benefit, thus diminishing the value of our products and services.

Abuse of our platforms may harm our reputation or user engagement.

Advertising, professional, and social platform abuses

For platform products and services that provide content or host ads that come from or can be influenced by third parties, including GitHub, LinkedIn, Microsoft Advertising, MSN, and Xbox Live, our reputation or user engagement may be negatively affected by activity that is hostile or inappropriate. This activity may come from users impersonating other people or organizations, use of our products or services to spread terrorist or violent extremist content or to disseminate information that may be viewed as misleading or intended to manipulate the opinions of our users, or the use of our products or services that violates our terms of service or otherwise for objectionable or illegal ends. Preventing or responding to these actions may require us to make substantial investments in people and technology and these investments may not be successful, adversely affecting our business and consolidated financial statements.

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Digital safety and service misuse

Our hosted consumer services as well as our enterprise services may be used by third parties to disseminate harmful or illegal content in violation of our terms or applicable law. We may not proactively discover such content due to scale and the limitations of existing technologies, and when discovered by users, such content may negatively affect our reputation, our brands, and user engagement. Regulations and other initiatives to make platforms responsible for preventing or eliminating harmful content online are gaining momentum and we expect this to continue. We may be subject to enhanced regulatory oversight, civil or criminal liability, or reputational damage if we fail to comply with content moderation regulations, adversely affecting our business and consolidated financial statements.

The development of the IoT presents security, privacy, and execution risks. To support the growth of the intelligent cloud and the intelligent edge, we are developing products, services, and technologies to power the IoT, a network of distributed and interconnected devices employing sensors, data, and computing capabilities including AI. The IoT’s great potential also carries substantial risks. IoT products and services may contain defects in design, manufacture, or operation that make them insecure or ineffective for their intended purposes. An IoT solution has multiple layers of hardware, sensors, processors, software, and firmware, several of which we may not develop or control. Each layer, including the weakest layer, can impact the security of the whole system. Many IoT devices have limited interfaces and ability to be updated or patched. IoT solutions may collect large amounts of data, and our handling of IoT data may not satisfy customers or regulatory requirements. IoT scenarios may increasingly affect personal health and safety. If IoT solutions that include our technologies do not work as intended, violate the law, or harm individuals or businesses, we may be subject to legal claims or enforcement actions. These risks, if realized, may increase our costs, damage our reputation or brands, or negatively impact our revenues or margins.

Issues in the use of AI in our offerings may result in reputational harm or liability. We are building AI into many of our offerings and we expect this element of our business to grow. We envision a future in which AI operating in our devices, applications, and the cloud helps our customers be more productive in their work and personal lives. As with many disruptive innovations, AI presents risks and challenges that could affect its adoption, and therefore our business. AI algorithms may be flawed. Datasets may be insufficient or contain biased information. Inappropriate or controversial data practices by Microsoft or others could impair the acceptance of AI solutions. These deficiencies could undermine the decisions, predictions, or analysis AI applications produce, subjecting us to competitive harm, legal liability, and brand or reputational harm. Some AI scenarios present ethical issues. If we enable or offer AI solutions that are controversial because of their impact on human rights, privacy, employment, or other social issues, we may experience brand or reputational harm.

We may have excessive outages, data losses, and disruptions of our online services if we fail to maintain an adequate operations infrastructure. Our increasing user traffic, growth in services, and the complexity of our products and services demand more computing power. We spend substantial amounts to build, purchase, or lease datacenters and equipment and to upgrade our technology and network infrastructure to handle more traffic on our websites and in our datacenters. These demands continue to increase as we introduce new products and services and support the growth of existing services such as Bing, Azure, Microsoft Account services, Microsoft 365, Microsoft Teams, Dynamics 365, OneDrive, SharePoint Online, Skype, Xbox Live, and Outlook.com. We are rapidly growing our business of providing a platform and back-end hosting for services provided by third parties to their end users. Maintaining, securing, and expanding this infrastructure is expensive and complex, and requires development of principles for datacenter builds in geographies with higher safety risks. It requires that we maintain an Internet connectivity infrastructure and storage and compute capacity that is robust and reliable within competitive and regulatory constraints that continue to evolve. Inefficiencies or operational failures, including temporary or permanent loss of customer data, insufficient Internet connectivity, or inadequate storage and compute capacity, could diminish the quality of our products, services, and user experience resulting in contractual liability, claims by customers and other third parties, regulatory actions, damage to our reputation, and loss of current and potential users, subscribers, and advertisers, each of which may adversely impact our consolidated financial statements.

We may experience quality or supply problems. Our hardware products such as Xbox consoles, Surface devices, and other devices we design, manufacture, and market are highly complex and can have defects in design, manufacture, or associated software. We could incur significant expenses, lost revenue, and reputational harm as a result of recalls, safety alerts, or product liability claims if we fail to prevent, detect, or address such issues through design, testing, or warranty repairs.

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Our software products and services also may experience quality or reliability problems. The highly sophisticated software we develop may contain bugs and other defects that interfere with their intended operation. Our customers increasingly rely on us for critical functions, potentially magnifying the impact of quality or reliability issues. Any defects we do not detect and fix in pre-release testing could cause reduced sales and revenue, damage to our reputation, repair or remediation costs, delays in the release of new products or versions, or legal liability. Although our license agreements typically contain provisions that eliminate or limit our exposure to liability, there is no assurance these provisions will withstand legal challenge.

We acquire some device and datacenter components from sole suppliers. Our competitors use some of the same suppliers and their demand for hardware components can affect the capacity available to us. If a component from a sole-source supplier is delayed or becomes unavailable, whether because of supplier capacity constraint, industry shortages, legal or regulatory changes, or other reasons, we may not obtain timely replacement supplies, resulting in reduced sales or inadequate datacenter capacity. Component shortages, excess or obsolete inventory, or price reductions resulting in inventory adjustments may increase our cost of revenue. Xbox consoles, Surface devices, datacenter servers, and other hardware are assembled in Asia and other geographies that may be subject to disruptions in the supply chain, resulting in shortages that would affect our revenue and operating margins. These same risks would apply to any other hardware and software products we may offer.

We may not be able to protect our source code from copying if there is an unauthorized disclosure. Source code, the detailed program commands for our operating systems and other software programs, is critical to our business. Although we license portions of our application and operating system source code to several licensees, we take significant measures to protect the secrecy of large portions of our source code. If our source code leaks, we might lose future trade secret protection for that code. It may then become easier for third parties to compete with our products by copying functionality, which could adversely affect our revenue and operating margins. Unauthorized disclosure of source code also could increase the security risks described elsewhere in these risk factors.

Legal changes, our evolving business model, piracy, and other factors may decrease the value of our intellectual property. Protecting our intellectual property rights and combating unlicensed copying and use of our software and other intellectual property on a global basis is difficult. While piracy adversely affects U.S. revenue, the impact on revenue from outside the U.S. is more significant, particularly countries in which the legal system provides less protection for intellectual property rights. Our revenue in these markets may grow more slowly than the underlying device market. Similarly, the absence of harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Throughout the world, we educate users about the benefits of licensing genuine products and obtaining indemnification benefits for intellectual property risks, and we educate lawmakers about the advantages of a business climate where intellectual property rights are protected. Reductions in the legal protection for software intellectual property rights could adversely affect revenue.

We expend significant resources to patent the intellectual property we create with the expectation that we will generate revenues by incorporating that intellectual property in our products or services or, in some instances, by licensing our patents to others in return for a royalty. Changes in the law may continue to weaken our ability to prevent the use of patented technology or collect revenue for licensing our patents. These include legislative changes and regulatory actions that make it more difficult to obtain injunctions, and the increasing use of legal process to challenge issued patents. Similarly, licensees of our patents may fail to satisfy their obligations to pay us royalties, or may contest the scope and extent of their obligations. The royalties we can obtain to monetize our intellectual property may decline because of the evolution of technology, price changes in products using licensed patents, or the difficulty of discovering infringements. Finally, our increasing engagement with open source software will also cause us to license our intellectual property rights broadly in certain situations and may negatively impact revenue.

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Third parties may claim we infringe their intellectual property rights. From time to time, others claim we infringe their intellectual property rights. The number of these claims may grow because of constant technological change in the markets in which we compete, the extensive patent coverage of existing technologies, the rapid rate of issuance of new patents, and our offering of first-party devices, such as Surface. To resolve these claims, we may enter into royalty and licensing agreements on terms that are less favorable than currently available, stop selling or redesign affected products or services, or pay damages to satisfy indemnification commitments with our customers. These outcomes may cause operating margins to decline. Besides money damages, in some jurisdictions plaintiffs can seek injunctive relief that may limit or prevent importing, marketing, and selling our products or services that have infringing technologies. In some countries, such as Germany, an injunction can be issued before the parties have fully litigated the validity of the underlying patents. We have paid significant amounts to settle claims related to the use of technology and intellectual property rights and to procure intellectual property rights as part of our strategy to manage this risk, and may continue to do so.

We have claims and lawsuits against us that may result in adverse outcomes. We are subject to a variety of claims and lawsuits. These claims may arise from a wide variety of business practices and initiatives, including major new product releases such as Windows 10, significant business transactions, warranty or product claims, and employment practices. Adverse outcomes in some or all of these claims may result in significant monetary damages or injunctive relief that could adversely affect our ability to conduct our business. The litigation and other claims are subject to inherent uncertainties and management’s view of these matters may change in the future. A material adverse impact in our consolidated financial statements could occur for the period in which the effect of an unfavorable outcome becomes probable and reasonably estimable.

Government litigation and regulatory activity relating to competition rules may limit how we design and market our products. As a leading global software and device maker, government agencies closely scrutinize us under U.S. and foreign competition laws. Governments are actively enforcing competition laws and regulations, and this includes scrutiny in potentially large markets such as the European Union (“EU”), the U.S., and China. Some jurisdictions also allow competitors or consumers to assert claims of anti-competitive conduct. U.S. federal and state antitrust authorities have previously brought enforcement actions and continue to scrutinize our business.

The European Commission (“the Commission”) closely scrutinizes the design of high-volume Microsoft products and the terms on which we make certain technologies used in these products, such as file formats, programming interfaces, and protocols, available to other companies. Flagship product releases such as Windows 10 can receive significant scrutiny under competition laws. For example, in 2004, the Commission ordered us to create new versions of our Windows operating system that do not include certain multimedia technologies and to provide our competitors with specifications for how to implement certain proprietary Windows communications protocols in their own products. In 2009, the Commission accepted a set of commitments we offered to address the Commission’s concerns relating to competition in web browsing software, including an undertaking to address Commission concerns relating to interoperability. The web browsing commitments expired in 2014. The remaining obligations may limit our ability to innovate in Windows or other products in the future, diminish the developer appeal of the Windows platform, and increase our product development costs. The availability of licenses related to protocols and file formats may enable competitors to develop software products that better mimic the functionality of our products, which could hamper sales of our products.

Our portfolio of first-party devices continues to grow; at the same time our OEM partners offer a large variety of devices for our platforms. As a result, increasingly we both cooperate and compete with our OEM partners, creating a risk that we fail to do so in compliance with competition rules. Regulatory scrutiny in this area may increase. Certain foreign governments, particularly in China and other countries in Asia, have advanced arguments under their competition laws that exert downward pressure on royalties for our intellectual property.

Government regulatory actions and court decisions such as these may result in fines, or hinder our ability to provide the benefits of our software to consumers and businesses, reducing the attractiveness of our products and the revenue that come from them. New competition law actions could be initiated, potentially using previous actions as precedent. The outcome of such actions, or steps taken to avoid them, could adversely affect us in a variety of ways, including:

 

We may have to choose between withdrawing products from certain geographies to avoid fines or designing and developing alternative versions of those products to comply with government rulings, which may entail a delay in a product release and removing functionality that customers want or on which developers rely.

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We may be required to make available licenses to our proprietary technologies on terms that do not reflect their fair market value or do not protect our associated intellectual property.

 

We are subject to a variety of ongoing commitments because of court or administrative orders, consent decrees, or other voluntary actions we have taken. If we fail to comply with these commitments, we may incur litigation costs and be subject to substantial fines or other remedial actions.

 

Our ability to realize anticipated Windows 10 post-sale monetization opportunities may be limited.

Our global operations subject us to potential liability under anti-corruption, trade protection, and other laws and regulations. The Foreign Corrupt Practices Act (“FCPA”) and other anti-corruption laws and regulations (“Anti-Corruption Laws”) prohibit corrupt payments by our employees, vendors, or agents, and the accounting provisions of the FCPA require us to maintain accurate books and records and adequate internal controls. From time to time, we receive inquiries from authorities in the U.S. and elsewhere which may be based on reports from employees and others about our business activities outside the U.S. and our compliance with Anti-Corruption Laws. Periodically, we receive such reports directly and investigate them. On July 22, 2019, our Hungarian subsidiary entered into a non-prosecution agreement (“NPA”) with the U.S. Department of Justice (“DOJ”) and we agreed to the terms of a cease and desist order with the Securities and Exchange Commission. These agreements required us to pay $25.3 million in monetary penalties, disgorgement, and interest pertaining to activities at Microsoft’s subsidiary in Hungary. The NPA, which has a three-year term, also contains certain ongoing compliance requirements, including the obligations to disclose to the DOJ issues that may implicate the FCPA and to cooperate in any inquiries. Most countries in which we operate also have competition laws that prohibit competitors from colluding or otherwise attempting to reduce competition between themselves. While we devote substantial resources to our U.S. and international compliance programs and have implemented policies, training, and internal controls designed to reduce the risk of corrupt payments and collusive activity, our employees, vendors, or agents may violate our policies. Our failure to comply with Anti-Corruption Laws or competition laws could result in significant fines and penalties, criminal sanctions against us, our officers, or our employees, prohibitions on the conduct of our business, and damage to our reputation. Operations outside the U.S. may be affected by changes in trade protection laws, policies, sanctions, and other regulatory requirements affecting trade and investment. We may be subject to legal liability and reputational damage if we sell goods or services in violation of U.S. trade sanctions on restricted entities or countries such as Crimea, Cuba, Iran, North Korea, Sudan, and Syria.

Other regulatory areas that may apply to our products and online services offerings include user privacy, telecommunications, data storage and protection, advertising, and online content. For example, some regulators are taking the position that our offerings such as Microsoft Teams and Skype are covered by existing laws regulating telecommunications services, and some new laws, including EU Member State laws under the European Electronic Communications Code, are defining more of our services as regulated telecommunications services. This trend may continue and will result in these offerings being subjected to additional data protection, security, and law enforcement surveillance obligations. Data protection authorities may assert that our collection, use, and management of customer data is inconsistent with their laws and regulations. Legislative or regulatory action relating to cybersecurity requirements may increase the costs to develop, implement, or secure our products and services. Legislative or regulatory action could also emerge in the area of AI and content moderation, increasing costs or restricting opportunity. Applying these laws and regulations to our business is often unclear, subject to change over time, and sometimes may conflict from jurisdiction to jurisdiction. Additionally, these laws and governments’ approach to their enforcement, and our products and services, are continuing to evolve. Compliance with these types of regulation may involve significant costs or require changes in products or business practices that result in reduced revenue. Noncompliance could result in the imposition of penalties or orders we stop the alleged noncompliant activity.

We strive to empower all people and organizations to achieve more, and accessibility of our products is an important aspect of this goal. There is increasing pressure from advocacy groups, regulators, competitors, customers, and other stakeholders to make technology more accessible. If our products do not meet customer expectations or global accessibility requirements, we could lose sales opportunities or face regulatory actions.

51


PART II

Item 1A

 

Laws and regulations relating to the handling of personal data may impede the adoption of our services or result in increased costs, legal claims, fines against us, or reputational damage. The growth of our Internet- and cloud-based services internationally relies increasingly on the movement of data across national boundaries. Legal requirements relating to the collection, storage, handling, and transfer of personal data continue to evolve. For example, in July 2020 the Court of Justice of the EU invalidated a framework called Privacy Shield for companies to transfer data from EU member states to the United States. This ruling has led to uncertainty about the legal requirements for data transfers from the EU under other legal mechanisms. Potential new rules and restrictions on the flow of data across borders could increase the cost and complexity of delivering our products and services in some markets. In May 2018, the EU General Data Protection Regulation (“GDPR”), became effective. The law, which applies to all of our activities conducted from an establishment in the EU or related to products and services offered in the EU, imposes a range of compliance obligations regarding the handling of personal data. Engineering efforts to build and maintain capabilities to facilitate compliance with the law have entailed substantial expense and the diversion of engineering resources from other projects and may continue to do so. We might experience reduced demand for our offerings if we are unable to engineer products that meet our legal duties or help our customers meet their obligations under the GDPR or other data regulations, or if our implementation to comply with the GDPR makes our offerings less attractive. The GDPR imposes significant new obligations and compliance with these obligations depends in part on how particular regulators interpret and apply them. If we fail to comply with the GDPR, or if regulators assert we have failed to comply with the GDPR, it may lead to regulatory enforcement actions, which can result in monetary penalties of up to 4% of worldwide revenue, private lawsuits, reputational damage, and loss of customers. Countries around the world, and states in the U.S. such as California, have adopted, or are considering adopting or expanding, laws and regulations imposing obligations regarding the handling of personal data.

The Company’s investment in gaining insights from data is becoming central to the value of the services we deliver to customers, to our operational efficiency and key opportunities in monetization, customer perceptions of quality, and operational efficiency. Our ability to use data in this way may be constrained by regulatory developments that impede realizing the expected return from this investment. Ongoing legal analyses, reviews, and inquiries by regulators of Microsoft practices, or relevant practices of other organizations, may result in burdensome or inconsistent requirements, including data sovereignty and localization requirements, affecting the location, movement, collection, and use of our customer and internal employee data as well as the management of that data. Compliance with applicable laws and regulations regarding personal data may require changes in services, business practices, or internal systems that result in increased costs, lower revenue, reduced efficiency, or greater difficulty in competing with foreign-based firms. Compliance with data regulations might limit our ability to innovate or offer certain features and functionality in some jurisdictions where we operate. Failure to comply with existing or new rules may result in significant penalties or orders to stop the alleged noncompliant activity, as well as negative publicity and diversion of management time and effort.

We may have additional tax liabilities. We are subject to income taxes in the U.S. and many foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. For example, compliance with the 2017 United States Tax Cuts and Jobs Act (“TCJA”) may require the collection of information not regularly produced within the Company, the use of estimates in our consolidated financial statements, and the exercise of significant judgment in accounting for its provisions. As regulations and guidance evolve with respect to the TCJA, and as we gather more information and perform more analysis, our results may differ from previous estimates and may materially affect our consolidated financial statements.

We regularly are under audit by tax authorities in different jurisdictions. Although we believe that our provision for income taxes and our tax estimates are reasonable, tax authorities may disagree with certain positions we have taken. In addition, economic and political pressures to increase tax revenue in various jurisdictions may make resolving tax disputes favorably more difficult. We are currently under Internal Revenue Service audit for prior tax years, with the primary unresolved issues relating to transfer pricing. The final resolution of those audits, and other audits or litigation, may differ from the amounts recorded in our consolidated financial statements and may materially affect our consolidated financial statements in the period or periods in which that determination is made.

52


PART II

Item 1A

 

We earn a significant amount of our operating income outside the U.S. A change in the mix of earnings and losses in countries with differing statutory tax rates, changes in our business or structure, or the expiration of or disputes about certain tax agreements in a particular country may result in higher effective tax rates for the Company. In addition, changes in U.S. federal and state or international tax laws applicable to corporate multinationals, other fundamental law changes currently being considered by many countries, including in the U.S., and changes in taxing jurisdictions’ administrative interpretations, decisions, policies, and positions may materially adversely impact our consolidated financial statements.

If our reputation or our brands are damaged, our business and operating results may be harmed. Our reputation and brands are globally recognized and are important to our business. Our reputation and brands affect our ability to attract and retain consumer, business, and public-sector customers. There are numerous ways our reputation or brands could be damaged. These include product safety or quality issues, or our environmental impact and sustainability, supply chain practices, or human rights record. We may experience backlash from customers, government entities, advocacy groups, employees, and other stakeholders that disagree with our product offering decisions or public policy positions. Damage to our reputation or our brands may occur from, among other things:

 

The introduction of new features, products, services, or terms of service that customers, users, or partners do not like.

 

Public scrutiny of our decisions regarding user privacy, data practices, or content.

 

Data security breaches, compliance failures, or actions of partners or individual employees.

The proliferation of social media may increase the likelihood, speed, and magnitude of negative brand events. If our brands or reputation are damaged, it could negatively impact our revenues or margins, or ability to attract the most highly qualified employees.

Our global business exposes us to operational and economic risks. Our customers are located throughout the world and a significant part of our revenue comes from international sales. The global nature of our business creates operational, economic, and geopolitical risks. Our results of operations may be affected by global, regional, and local economic developments, monetary policy, inflation, and recession, as well as political and military disputes. In addition, our international growth strategy includes certain markets, the developing nature of which presents several risks, including deterioration of social, political, labor, or economic conditions in a country or region, and difficulties in staffing and managing foreign operations. Emerging nationalist and protectionist trends in specific countries may significantly alter the trade and commercial environments. Changes to trade policy or agreements as a result of populism, protectionism, or economic nationalism may result in higher tariffs, local sourcing initiatives, or other developments that make it more difficult to sell our products in foreign countries. Disruptions of these kinds in developed or emerging markets could negatively impact demand for our products and services or increase operating costs. Although we hedge a portion of our international currency exposure, significant fluctuations in foreign exchange rates between the U.S. dollar and foreign currencies may adversely affect our results of operations.

Our business with government customers may present additional uncertainties. We derive substantial revenue from government contracts. Government contracts generally can present risks and challenges not present in private commercial agreements. For instance, we may be subject to government audits and investigations relating to these contracts, we could be suspended or debarred as a governmental contractor, we could incur civil and criminal fines and penalties, and under certain circumstances contracts may be rescinded. Some agreements may allow a government to terminate without cause and provide for higher liability limits for certain losses. Some contracts may be subject to periodic funding approval, reductions, or delays which could adversely impact public-sector demand for our products and services. These events could negatively impact our results of operations, financial condition, and reputation.

Adverse economic or market conditions may harm our business. Worsening economic conditions, including inflation, recession, pandemic, or other changes in economic conditions, may cause lower IT spending and adversely affect our revenue. If demand for PCs, servers, and other computing devices declines, or consumer or business spending for those products declines, our revenue will be adversely affected.

Our product distribution system relies on an extensive partner and retail network. OEMs building devices that run our software have also been a significant means of distribution. The impact of economic conditions on our partners, such as the bankruptcy of a major distributor, OEM, or retailer, could cause sales channel disruption.

Challenging economic conditions also may impair the ability of our customers to pay for products and services they have purchased. As a result, allowances for doubtful accounts and write-offs of accounts receivable may increase.

53


PART II

Item 1A

 

We maintain an investment portfolio of various holdings, types, and maturities. These investments are subject to general credit, liquidity, market, and interest rate risks, which may be exacerbated by market downturns or events that affect global financial markets. A significant part of our investment portfolio comprises U.S. government securities. If global financial markets decline for long periods, or if there is a downgrade of the U.S. government credit rating due to an actual or threatened default on government debt, our investment portfolio may be adversely affected and we could determine that more of our investments have experienced a decline in fair value, requiring impairment charges that could adversely affect our consolidated financial statements.

Catastrophic events or geopolitical conditions may disrupt our business. A disruption or failure of our systems or operations because of a major earthquake, weather event, cyberattack, terrorist attack, pandemic, or other catastrophic event could cause delays in completing sales, providing services, or performing other critical functions. Our corporate headquarters, a significant portion of our research and development activities, and certain other essential business operations are in the Seattle, Washington area, and we have other business operations in the Silicon Valley area of California, both of which are seismically active regions. A catastrophic event that results in the destruction or disruption of any of our critical business or IT systems, or the infrastructure or systems they rely on, such as power grids, could harm our ability to conduct normal business operations. Providing our customers with more services and solutions in the cloud puts a premium on the resilience of our systems and strength of our business continuity management plans, and magnifies the potential impact of prolonged service outages in our consolidated financial statements.

Abrupt political change, terrorist activity, and armed conflict pose a risk of general economic disruption in affected countries, which may increase our operating costs. These conditions also may add uncertainty to the timing and budget for technology investment decisions by our customers, and may cause supply chain disruptions for hardware manufacturers. Geopolitical change may result in changing regulatory systems and requirements and market interventions that could impact our operating strategies, access to national, regional, and global markets, hiring, and profitability. Geopolitical instability may lead to sanctions and impact our ability to do business in some markets or with some public-sector customers. Any of these changes may negatively impact our revenues.

The occurrence of regional epidemics or a global pandemic may adversely affect our operations, financial condition, and results of operations. The COVID-19 pandemic is having widespread, rapidly evolving, and unpredictable impacts on global society, economies, financial markets, and business practices. Federal and state governments have implemented measures in an effort to contain the virus, including social distancing, travel restrictions, border closures, limitations on public gatherings, work from home, supply chain logistical changes, and closure of non-essential businesses. To protect the health and well-being of our employees, suppliers, and customers, we have made substantial modifications to employee travel policies, implemented office closures as employees are advised to work from home, and cancelled or shifted our conferences and other marketing events to virtual-only through fiscal year 2021. The COVID-19 pandemic has impacted and may continue to impact our business operations, including our employees, customers, partners, and communities, and there is substantial uncertainty in the nature and degree of its continued effects over time.

Since the COVID-19 pandemic began, we have experienced a range of impacts on our business, including adverse impacts to our supply chain, a slowdown in transactional licensing, and lower demand for our advertising services. The extent to which the COVID-19 pandemic impacts our business going forward will depend on numerous evolving factors we cannot reliably predict, including the duration and scope of the pandemic; governmental, business, and individuals' actions in response to the pandemic; and the impact on economic activity including the possibility of recession or financial market instability. These factors may adversely impact consumer, business, and government spending on technology as well as customers' ability to pay for our products and services on an ongoing basis. This uncertainty also affects management’s accounting estimates and assumptions, which could result in greater variability in a variety of areas that depend on these estimates and assumptions, including investments, receivables, and forward-looking guidance.

Measures to contain the virus that impact us, our partners, distributors, and suppliers may further intensify these impacts and other risks described in these Risk Factors. Any of these may adversely impact our ability to:

 

Maintain our operations infrastructure, including the reliability and adequate capacity of cloud services.

 

Satisfy our contractual and regulatory compliance obligations as we adapt to changing usage patterns, such as through datacenter load balancing.

54


PART II

Item 1A

 

 

Ensure a high-quality and consistent supply chain and manufacturing operations for our hardware devices and datacenter operations.

 

Effectively manage our international operations through changes in trade practices and policies.

 

Hire and deploy people where we most need them.

 

Sustain the effectiveness and productivity of our operations including our sales, marketing, engineering, and distribution functions.

We may incur increased costs to effectively manage these aspects of our business. If we are unsuccessful it may adversely impact our revenues, cash flows, market share growth, and reputation.

The long-term effects of climate change on the global economy and the IT industry in particular are unclear. Environmental regulations or changes in the supply, demand or available sources of energy or other resources may affect the availability or cost of goods and services, including natural resources, necessary to run our business. Changes in climate where we operate may increase the costs of powering and cooling computer hardware we use to develop software and provide cloud-based services.

Our business depends on our ability to attract and retain talented employees. Our business is based on successfully attracting and retaining talented employees representing diverse backgrounds, experiences, and skill sets. The market for highly skilled workers and leaders in our industry is extremely competitive. Maintaining our brand and reputation, as well as a diverse and inclusive work environment that enables all our employees to thrive, are important to our ability to recruit and retain employees. We are also limited in our ability to recruit internationally by restrictive domestic immigration laws. Changes to U.S. immigration policies that restrain the flow of technical and professional talent may inhibit our ability to adequately staff our research and development efforts. If we are less successful in our recruiting efforts, or if we cannot retain highly skilled workers and key leaders, our ability to develop and deliver successful products and services may be adversely affected. Effective succession planning is also important to our long-term success. Failure to ensure effective transfer of knowledge and smooth transitions involving key employees could hinder our strategic planning and execution. How employment-related laws are interpreted and applied to our workforce practices may result in increased operating costs and less flexibility in how we meet our workforce needs.

 

55


PART II

Item 2

 

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

SHARE REPURCHASES AND DIVIDENDS

Following are our monthly share repurchases for the first quarter of fiscal year 2021:

 

Period

 

Total Number

of Shares

Purchased

 

 

Average

Price Paid

per Share

 

 

Total Number

 of Shares

 Purchased as

Part of Publicly

Announced Plans

or Programs

 

 

Approximate

Dollar Value of

Shares that May

 Yet be Purchased

 under the Plans

or Programs

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(In millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

July 1, 2020 – July 31, 2020

 

 

9,748,145

 

 

$

206.48

 

 

 

9,748,145

 

 

$

29,699

 

August 1, 2020 – August 31, 2020

 

 

7,797,300

 

 

213.96

 

 

 

7,797,300

 

 

 

28,031

 

September 1, 2020 – September 30, 2020

 

 

7,606,666

 

 

208.88

 

 

 

7,606,666

 

 

 

26,442

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

25,152,111

 

 

 

 

 

 

 

25,152,111

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

All share repurchases were made using cash resources. Our share repurchases may occur through open market purchases or pursuant to a Rule 10b5-1 trading plan. The above table excludes shares repurchased to settle employee tax withholding related to the vesting of stock awards.

Our Board of Directors declared the following dividends during the first quarter of fiscal year 2021:

 

Declaration Date

 

 

Record Date

 

 

 

Payment Date

 

 

 

Dividend

Per Share

 

 

 

Amount

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(In millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

September 15, 2020

 

 

November 19, 2020

 

 

 

December 10, 2020

 

 

$

0.56

 

 

$

4,236

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

We returned $9.5 billion to shareholders in the form of share repurchases and dividends in the first quarter of fiscal year 2021. Refer to Note 15 – Stockholders’ Equity of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion regarding share repurchases and dividends.

 

 

56


PART II

Item 6

 

ITEM 6. EXHIBITS

 

15.1

 

Letter regarding unaudited interim financial information

 

 

31.1

 

Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

 

31.2

 

Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

 

32.1*

 

Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

 

32.2*

 

Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

 

101.INS

 

Inline XBRL Instance Document—the instance document does not appear in the Interactive Data File as its XBRL tags are embedded within the Inline XBRL document

 

 

101.SCH

 

Inline XBRL Taxonomy Extension Schema

 

 

101.CAL

 

Inline XBRL Taxonomy Extension Calculation Linkbase

 

 

101.DEF

 

Inline XBRL Taxonomy Extension Definition Linkbase

 

 

101.LAB

 

Inline XBRL Taxonomy Extension Label Linkbase

 

 

101.PRE

 

Inline XBRL Taxonomy Extension Presentation Linkbase

 

 

 

104

 

Cover page formatted as Inline XBRL and contained in Exhibit 101

 

*

Furnished, not filed.

Items 3, 4, and 5 are not applicable and have been omitted.

 

 

57


 

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned; thereunto duly authorized.

 

MICROSOFT CORPORATION

 

/S/ Alice L. Jolla

Alice L. Jolla

Corporate Vice President and Chief Accounting Officer

(Duly Authorized Officer)

 

October 27, 2020

 

 

58