Table of Contents UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended December 31, 2006 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: 0-14278 MICROSOFT CORPORATION (Exact name of registrant as specified in its charter) Washington 91-1144442 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) One Microsoft Way, Redmond, Washington 98052-6399 (Address of principal executive offices) (Zip Code) (425) 882-8080 (Registrant’s telephone number, including area code) None (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. Class Outstanding at January 22, 2007 Common Stock, $0.00000625 par value per share 9,792,314,405 shares Table of Contents MICROSOFT CORPORATION FORM 10-Q For the Quarter Ended December 31, 2006 INDEX Page Part I. Financial Information Item 1. Financial Statements a) Income Statements for the Three and Six Months Ended December 31, 2006 and 2005 1 b) Balance Sheets as of December 31, 2006 and June 30, 2006 2 c) Cash Flows Statements for the Three and Six Months Ended December 31, 2006 and 2005 3 d) Stockholders’ Equity Statements for the Three and Six Months Ended December 31, 2006 and 2005 4 e) Notes to Financial Statements 5 f) Report of Independent Registered Public Accounting Firm 14 Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 15 Item 3. Quantitative and Qualitative Disclosures About Market Risk 29 Item 4. Controls and Procedures 30 Part II. Other Information Item 1. Legal Proceedings 31 Item 1A. Risk Factors 31 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 37 Item 4. Submission of Matters to a Vote of Security Holders 38 Item 6. Exhibits 39 Signature 40 Table of Contents Part I. Financial Information Item 1. Financial Statements MICROSOFT CORPORATION INCOME STATEMENTS (In millions, except per share amounts)(Unaudited) Three Months Ended Six Months Ended December 31, December 31, 2006 2005 2006 2005 Revenue $12,542 $11,837 $23,353 $21,578 Operating expenses: Cost of revenue 3,620 2,239 5,316 3,492 Research and development 1,637 1,591 3,423 3,106 Sales and marketing 2,999 2,689 5,190 4,634 General and administrative 814 661 1,478 1,643 Total operating expenses 9,070 7,180 15,407 12,875 Operating income 3,472 4,657 7,946 8,703 Investment income and other 333 480 900 986 Income before income taxes 3,805 5,137 8,846 9,689 Provision for income taxes 1,179 1,484 2,742 2,895 Net income $ 2,626 $ 3,653 $ 6,104 $ 6,794 Earnings per share: Basic $ 0.27 $ 0.35 $ 0.62 $ 0.64 Diluted $ 0.26 $ 0.34 $ 0.61 $ 0.63 Weighted average shares outstanding: Basic 9,806 10,560 9,867 10,628 Diluted 9,942 10,638 9,996 10,708 Cash dividends declared per common share $ 0.10 $ 0.09 $ 0.20 $ 0.17 See accompanying notes. 1 Table of Contents MICROSOFT CORPORATION BALANCE SHEETS (In millions) December 31, June 30, 2006 2006(1) (Unaudited) Assets Current assets: Cash and equivalents $ 6,859 $ 6,714 Short-term investments (including securities pledged as collateral of $2,473 and $3,065) 22,014 27,447 Total cash, equivalents, and short-term investments 28,873 34,161 Accounts receivable, net of allowance for doubtful accounts of $136 and $142 9,895 9,316 Inventories, net 1,725 1,478 Deferred income taxes 2,607 1,940 Other 2,080 2,115 Total current assets 45,180 49,010 Property and equipment, net 3,686 3,044 Equity and other investments 9,631 9,232 Goodwill 4,189 3,866 Intangible assets, net 745 539 Deferred income taxes 1,656 2,611 Other long-term assets 1,284 1,295 Total assets $ 66,371 $ 69,597 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 2,944 $ 2,909 Accrued compensation 1,559 1,938 Income taxes 1,337 1,557 Short-term unearned revenue 10,023 9,138 Securities lending payable 2,713 3,117 Other 3,639 3,783 Total current liabilities 22,215 22,442 Long-term unearned revenue 1,838 1,764 Other long-term liabilities 5,684 5,287 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital—shares authorized 24,000; outstanding 9,777 and 10,062 61,152 59,005 Retained deficit, including accumulated other comprehensive income of $1,582 and $1,229 (24,518) (18,901) Total stockholders’ equity 36,634 40,104 Total liabilities and stockholders’ equity $ 66,371 $ 69,597 (1) Derived from audited financial statements See accompanying notes. 2 Table of Contents MICROSOFT CORPORATION CASH FLOWS STATEMENTS (In millions)(Unaudited) Three Months Ended Six Months Ended December 31, December 31, 2006 2005 2006 2005 Operations Net income $ 2,626 $ 3,653 $ 6,104 $ 6,794 Depreciation, amortization, and other noncash items 365 231 614 465 Stock-based compensation expense 437 514 893 978 Net recognized gains on investments (29) (75) (235) (205) Excess tax benefits from stock-based payment arrangements (8) (13) (48) (44) Deferred income taxes (517) 170 (351) 42 Unearned revenue 6,029 3,670 9,246 6,702 Recognition of unearned revenue (4,265) (3,622) (8,315) (7,041) Accounts receivable (2,945) (2,012) (444) (604) Other current assets 723 (354) (357) (694) Other long-term assets (264) (10) (399) (8) Other current liabilities (354) (89) (1,196) (298) Other long-term liabilities 244 168 591 473 Net cash from operations 2,042 2,231 6,103 6,560 Financing Common stock issued 4,449 466 4,834 1,467 Common stock repurchased (5,797) (7,435) (13,480) (10,551) Common stock cash dividends (980) (846) (1,877) (1,703) Excess tax benefits from stock-based payment arrangements 8 13 48 44 Other (3) 0 (23) 0 Net cash used for financing (2,323) (7,802) (10,498) (10,743) Investing Additions to property and equipment (572) (318) (983) (531) Acquisition of companies, net of cash acquired (125) (63) (461) (250) Purchases of investments (9,102) (16,151) (21,957) (35,561) Maturities of investments 1,325 743 2,159 1,692 Sales of investments 7,448 22,481 26,149 38,081 Securities lending payable (932) 0 (404) 0 Net cash from (used for) investing (1,958) 6,692 4,503 3,431 Net change in cash and equivalents (2,239) 1,121 108 (752) Effect of exchange rates on cash and equivalents 22 (12) 37 (16) Cash and equivalents, beginning of period 9,076 2,974 6,714 4,851 Cash and equivalents, end of period $ 6,859 $ 4,083 $ 6,859 $ 4,083 See accompanying notes. 3 Table of Contents MICROSOFT CORPORATION STOCKHOLDERS’ EQUITY STATEMENTS (In millions)(Unaudited) Three Months Ended Six Months Ended December 31, December 31, 2006 2005 2006 2005 Common stock and paid-in capital Balance, beginning of period $ 57,657 $ 60,862 $ 59,005 $ 60,413 Common stock issued 4,436 462 4,834 1,289 Common stock repurchased (1,232) (1,629) (3,106) (2,360) Stock-based compensation expense 437 514 893 978 Stock option income tax deficiencies (147) (69) (481) (181) Other, net 1 0 7 1 Balance, end of period 61,152 60,140 61,152 60,140 Retained deficit Balance, beginning of period (21,556) (12,535) (18,901) (12,298) Net income 2,626 3,653 6,104 6,794 Other comprehensive income: Net gains/(losses) on derivative instruments (1) 94 (28) 136 Net unrealized investments gains/(losses) 184 (156) 337 (333) Translation adjustments and other 35 (13) 44 (19) Comprehensive income 2,844 3,578 6,457 6,578 Common stock cash dividends (974) (928) (1,949) (1,780) Common stock repurchased (4,832) (6,047) (10,125) (8,432) Balance, end of period (24,518) (15,932) (24,518) (15,932) Total stockholders’ equity $ 36,634 $ 44,208 $ 36,634 $ 44,208 See accompanying notes. 4 Table of Contents MICROSOFT CORPORATION NOTES TO FINANCIAL STATEMENTS (Unaudited) Note 1 – Basis of Presentation and Consolidation Basis of Presentation In the opinion of management, the accompanying balance sheets and related interim statements of income, cash flows, and stockholders’ equity include all adjustments, consisting only of normal recurring items, necessary for their fair presentation in conformity with accounting principles generally accepted in the United States of America (“U.S.