RESULTS OF OPERATIONS FOR 2000, 2001, AND 2002

Management’s Discussion and Analysis contains statements that are forward-looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in “Issues and Uncertainties.”

REVENUE

The Company’s revenue growth rate was 16% in fiscal 2000, 10% in fiscal 2001, and 12% in fiscal 2002. Revenue growth in fiscal 2002 was led by the addition of Xbox video game system revenue and the strong penetration of Microsoft Windows XP Professional and Home operating systems. Revenue growth in fiscal 2001 was driven primarily by licensing of Microsoft Windows 2000 Professional, Microsoft SQL Server, and the other .NET Enterprise Servers. Revenue growth in fiscal 2000 was driven by strong licensing of Microsoft Windows NT Workstation, Windows 2000 Professional, Windows NT Server, Windows 2000 Server, Microsoft Office 2000, and SQL Server.
      Microsoft continued to see a mix shift to volume licensing programs. On October 1, 2001, Microsoft launched Licensing 6.0 to simplify and improve its volume licensing programs, including a simplified approach to software upgrades. One feature of Licensing 6.0 is Software Assurance which gives customers the right to install any new release of products covered in the licensing agreement during the term of their coverage. The success of Microsoft’s new volume licensing programs will continue to affect the mix of multi-year licensing agreements with a resulting impact on the timing of revenue recognition. In addition, the timing and extent of a recovery in consumer and corporate spending on PCs and information technology (IT) will be factors affecting revenue growth.

PRODUCT REVENUE

In fiscal 2002, Microsoft had four segments: Desktop and Enterprise Software and Services; Consumer Software, Services, and Devices; Consumer Commerce Investments; and Other. The revenue figures in this Management’s Discussion and Analysis (MD&A) differ from those reported in the Company’s Segment Information appearing in Note 20 of the Notes to Financial Statements. The revenue figures in the Segment Information represent amounts reported internally for management reporting, while the revenue figures in the MD&A reflect revenue recognized in accordance with generally accepted accounting principles. On July 1, 2002, Microsoft revised its product segments and will begin reporting the new segments in fiscal 2003.

Desktop and Enterprise Software and Services. Desktop and Enterprise Software and Services revenue was $20.40 billion, $22.41 billion, and $24.01 billion in 2000, 2001, and 2002. Desktop and Enterprise Software and Services includes Desktop Applications; Desktop Platforms; and Enterprise Software and Services.
      Desktop Applications revenue was $9.30 billion, $9.54 billion, and $9.60 billion in 2000, 2001, and 2002. Desktop Applications includes revenue from Microsoft Office; Microsoft Project; Visio; client access licenses (CALs) for Windows NT Server and Windows 2000 Server, Exchange, and BackOffice; Microsoft Great Plains; and bCentral. In fiscal 2002, Office licensing revenue declined during the year due to a strong mix shift to multi-year annuity licensing agreements, which deferred revenue recognition to future years, and a decrease in consumer purchases in the Asia region, most notably Japan, partially offset by strong OEM licensing. Revenue from client access licenses grew 3% in fiscal 2002 and revenue from Great Plains contributed to the growth in Desktop Applications. In fiscal 2001, revenue from client access licenses increased 14% reflecting strong licensing growth of Windows NT Server and Windows 2000 Server CALs. Office revenue growth was flat during fiscal 2001. In fiscal 2000, revenue growth from Microsoft Office integrated suites, including the Premium, Professional, Small Business, and Standard Editions was very solid.
      Desktop Platforms revenue was $7.02 billion, $8.04 billion, and $9.30 billion in 2000, 2001, and 2002. Desktop Platforms includes revenue from Windows XP Professional and Home, Windows 2000 Professional, Windows NT Workstation, Windows Me, Windows 98, and other desktop operating systems. In fiscal 2002, the growth in Desktop Platforms revenue reflected strong multi-year licensing revenue growth and a continued mix shift to the higher priced Windows 2000 and Windows XP Professional operating system through OEMs, despite a decline in reported OEM unit shipments. Fiscal 2001 revenue growth reflected the strong adoption of Windows 2000 Professional, partially offset by flat revenue growth from Windows Me and Windows 98 operating systems, reflecting the slowdown in consumer PC shipments and a higher mix of Windows 2000 Professional and Windows NT Workstation. In fiscal 2000, Desktop Platforms revenue growth was modest due to soft demand for business PCs during most of the year; a slowdown in shipments in anticipation of the post mid-year availability of Windows 2000 operating systems; and, as expected, a longer business migration cycle for the newest Windows operating system offerings. The rate of growth in PC shipments and the mix of Windows 2000 and Windows XP Professional as a percentage of all 32-bit operating systems will continue to impact revenue growth in the future.
      Enterprise Software and Services revenue was $4.08 billion, $4.83 billion, and $5.11 billion in 2000, 2001, and 2002. Enterprise Software and Services includes Server Platforms, Server Applications, Developer Tools and Services, and Enterprise Services. In fiscal 2002, Server Applications, including Microsoft SQL Server and .NET Enterprise Servers, increased 10% compared to fiscal 2001. Server Platform revenue, which includes Windows 2000 Server and Windows NT Server operating systems, increased 10% versus fiscal 2001 driven by a modest overall increase in Windows-based server shipments and increased deployment of Windows 2000 Server. Enterprise Services revenue, representing consulting and product support services, was up 17% compared to fiscal 2001, while revenue from Developer Tools and Services was down 19% from fiscal 2001. In fiscal 2001, Server Applications revenue increased 31% versus the prior year as a result of the continued adoption of Microsoft’s .NET Enterprise Server offerings. Enterprise Services revenue in fiscal 2001, was up 34% compared to fiscal 2000 and Server Platforms increased 10% while revenue from Developer Tools and Services was flat. In fiscal 2000, Server Platforms revenue growth was particularly strong led by increased adoption by customers of Windows NT Server and Windows 2000 Server. Revenue from Server Applications grew strongly in fiscal 2000, largely due to the strong success of SQL Server 7.0, while Software Developer Tools and Services revenue declined, due to increased suite licensing versus stand-alone licenses, and the lack of a release upgrade of the Visual Studio development system.

Consumer Software, Services, and Devices.     Consumer Software, Services, and Devices revenue was $1.63 billion, $1.95 billion, and $3.59 billion in 2000, 2001, and 2002. Consumer Software, Services, and Devices includes the Xbox video game system; MSN Internet access; MSN network service; PC and online games; learning and productivity software; mobility; and embedded systems. The majority of the revenue growth from fiscal 2001 stemmed from sales of the Xbox video game system released in fiscal 2002. MSN Internet access revenue increased as a result of both a higher subscriber base and higher average revenue per subscriber due to a reduction in promotional subscriber programs. Revenue from MSN network services increased despite a declining Internet advertising market. Revenue from embedded systems in fiscal 2002 grew nicely, however learning and productivity software revenue and PC and online games declined compared to fiscal 2001. In fiscal 2001, revenue from MSN network services grew strongly despite a decline in the online advertising market. MSN Internet access revenue also grew solidly from fiscal 2000 as a result of an increased subscriber base, partially offset by a decline in the average revenue per subscriber due to a larger mix of subscribers contracted under rebate programs. Revenue from embedded systems grew strongly from the prior year, while learning and productivity software revenue and PC and online games revenue declined, reflecting softness in the overall consumer market. In fiscal 2000, online revenue growth was very strong and reflected higher subscriber totals, offset by lower net prices for Internet access subscriptions compared to the prior year. Additionally, strong sales of entertainment software in fiscal 2000 produced robust revenue growth in PC and online games.

Consumer Commerce Investments.     Consumer Commerce Investments revenue was $182 million, $299 million, and $242 million in 2000, 2001, and 2002. Consumer Commerce Investments include Expedia, Inc., the HomeAdvisor online real estate service, and the CarPoint online automotive service. The decline in revenue compared to fiscal 2001 reflects the sale of Microsoft’s majority ownership of Expedia, Inc. to USA Networks, Inc. on February 4, 2002. Acquisitions of Travelscape.com and VacationSpot.com by Expedia, Inc., and increased product offerings from Expedia led to the strong revenue growth in fiscal 2001. The increased overall reach of all properties led to the strong revenue growth in fiscal 2000.

Other.     Other revenue, which primarily includes Hardware and Microsoft Press, was $754 million, $630 million, and $530 million in 2000, 2001, and 2002. In fiscal 2002, continued declines in the IT book and consumer market led to a decline in Microsoft Press and Hardware sales. Lower sales of gaming devices and other hardware peripherals as a result of weakness in the consumer market caused the decline in revenue in fiscal 2001. Continued success of the Company’s new hardware device offerings led to revenue growth in fiscal 2000.

DISTRIBUTION CHANNELS

Microsoft distributes its products primarily through the following channels: OEM; volume licensing; online services and products; and distributors and retailers. OEM channel revenue represents license fees from original equipment manufacturers who preinstall Microsoft products, primarily on PCs. Microsoft has three major geographic sales and marketing regions: the South Pacific and Americas Region; the Europe, Middle East, and Africa Region; and the Asia Region. Sales of volume licenses and packaged software products via these channels are primarily to distributors and resellers.
      OEM revenue was $7.01 billion in 2000, $7.86 billion in 2001, and $9.00 billion in 2002. In fiscal 2002, reported licenses declined compared to fiscal 2001. However, a strong increase in the mix of the higher priced Windows 2000 and Windows XP Professional licenses, and healthy growth in direct and system builder OEMs licenses, led to higher average revenue per license and contributed to the overall OEM revenue growth over fiscal 2001. In fiscal 2001, while total licenses were also impacted by a slowdown in PC shipments, the mix of the higher priced Windows 2000 Professional and Windows NT Workstation increased substantially resulting in higher average revenue per license. A relatively low growth rate in fiscal 2000 was due to lower business PC shipment growth combined with post mid-year availability of Windows 2000 Professional. Average earned revenue per license also declined in fiscal 2000 compared to the prior year, due in part to a mix shift to the lower-priced Windows 98 operating system reflecting the softness in demand for business PCs and lower prices on operating systems licensed through certain OEM channel sectors.
      South Pacific and Americas Region revenue was $8.33 billion, $9.52 billion, and $11.41 billion in 2000, 2001, and 2002. In fiscal 2002, the majority of the revenue growth was driven by sales of the Xbox video game system released during the year, as well as strong Windows XP Professional licensing, MSN subscription revenue, and revenue from Microsoft Great Plains. In fiscal 2001, revenue growth was led by strong licensing of Windows 2000 Professional and the family of .NET Enterprise Servers, particularly SQL Server 2000 and Exchange 2000 Server. Revenue from Enterprise services and MSN subscription and services also grew strongly in fiscal 2001. In fiscal 2000, Office 2000 integrated suites, Windows 2000 Server, online revenue, and SQL Server sales were the primary drivers of the revenue growth. Strong retail sales of hardware devices and consumer software also contributed to the growth over the prior year.
      Europe, Middle East, and Africa Region revenue was $5.02 billion, $4.86 billion, and $5.13 billion in 2000, 2001, and 2002. In fiscal 2002, the majority of the growth was a result of strong multi-year licensing revenue of Windows XP Home and Professional operating systems and Enterprise Software, as well as the addition of Xbox video game system revenue in the second half of the year. In fiscal 2001, weakening local currencies negatively impacted translated revenue compared to the prior year, while revenue from Windows 2000 Professional and the .NET Enterprise Server family of products was very healthy. In fiscal 2000, retail sales of Windows operating systems and Office licensing produced moderate growth in the region. Growth from SQL Server licensing, new hardware device offerings, and entertainment software was especially strong.
      Asia Region revenue was $2.60 billion in 2000, $3.06 billion in 2001, and $2.83 billion in 2002. In fiscal 2002, Asia region revenue declined most notably due to lower consumer PC shipments, which hampered revenue from localized versions of Microsoft Office 2000 and Microsoft Office XP, especially the Office Personal Edition. Xbox video game system sales partially offset the decline in Office revenue. In fiscal 2001, the region’s growth rate reflected strong revenue from localized versions of Microsoft Office 2000 and Microsoft Office XP, especially the Office Personal Edition. This growth was also attributable to Windows 2000 Professional and .NET Server applications licensing. In fiscal 2000, the region’s growth rate reflected strong performance resulting from improved local economic conditions. Revenue growth was also influenced by robust growth of localized versions of Microsoft Office 2000, especially the Office Personal Edition sold in Japan, Windows platform and server licensing, and strong adoption of SQL Server.
      The Company’s operating results are affected by foreign exchange rates. Approximately 30%, 27%, and 25% of the Company’s revenue was collected in foreign currencies during 2000, 2001, and 2002. Since a portion of local currency revenue is hedged and much of the Company’s international manufacturing costs and operating expenses are also incurred in local currencies, the impact of exchange rates is partially mitigated.

OPERATING EXPENSES

Cost of Revenue. Cost of revenue as a percent of revenue was 13.1% in 2000, 13.7% in 2001, and 18.3% in 2002. Cost of revenue in fiscal 2002 increased primarily due to costs related to Xbox. In fiscal 2001, higher support and service costs associated with the MSN Internet access and MSN network services were partially offset by the lower relative costs associated with organizational licensing and the drop in the mix of packaged product versus the prior year. Cost of revenue in fiscal 2000 reflected lower costs associated with WebTV Networks’ operations, partially offset by the growth in hardware peripherals costs.

Research and Development.     The discontinuation of goodwill amortization in fiscal 2002 in accordance with Statement of Financial Accounting Standards (SFAS) 142, Goodwill and Other Intangible Assets, offset the growth in headcount and development costs. In fiscal 2001, the increase in R&D expense was the result of higher headcount-related costs and investments in new product initiatives. The increase in fiscal 2000 was driven primarily by higher headcount-related costs. Prospectively, increased headcount and increased spending in Server Platforms, Home & Entertainment, Business Solutions and CE are currently expected to be significant factors affecting future research and development expense growth.

Sales and Marketing.     Sales and marketing expense as a percentage of revenue was 18.0% in 2000, 19.3% in 2001, and 19.1% in 2002. In fiscal 2002, sales and marketing expense as a percentage of revenue decreased due to lower relative MSN customer acquisition marketing and the large relative increase associated with the onset of Xbox video game system revenue. In fiscal 2001, sales and marketing expenses as a percentage of revenue increased due to higher relative headcount-related costs, higher marketing and sales expenses associated with MSN, the Microsoft Agility advertising campaign, and other new sales initiatives. In fiscal 2000, sales and marketing expenses as a percentage of revenue increased due to higher relative marketing costs associated with new product releases and online marketing. Microsoft expects that it will increase spending on Information Worker, Server Platforms, and Business Solutions sales forces and Windows Client, MSN and Home & Entertainment marketing.

General and Administrative.     General and administrative expenses in fiscal 2002 increased due to a charge of approximately $660 million for estimated expenses related to the Company’s consumer class action lawsuits and higher legal fees. In fiscal 2001, general and administrative costs decreased due to a charge related to the settlement of the lawsuit with Caldera, Inc. recorded in fiscal 2000. Excluding this charge in fiscal 2000, general and administrative expenses in fiscal 2001 increased from the prior year due to higher headcount-related costs and legal fees. For fiscal 2000, besides the settlement of the lawsuit, general and administrative expenses also reflected increased legal fees and certain employee stock option-related expenses.

NON-OPERATING ITEMS, INVESTMENT INCOME/(LOSS), AND INCOME TAXES

Losses on equity investees and other consists of Microsoft’s share of income or loss from investments accounted for using the equity method, and income or loss attributable to minority interests. The decrease in losses on equity investees and other in fiscal 2002 was attributed to the divestiture of certain equity investments in fiscal 2002. The increase in losses on equity investees and other in fiscal 2001 reflects an increase in the number of such investments during the year. In fiscal 2000 losses on equity investees and other decreased reflecting smaller losses from the MSNBC entities.
     The Company recorded net investment income/(loss) in each year as follows:

     In fiscal 2002, other-than-temporary impairments primarily related to the Company’s investment in AT&T and other cable and telecommunication investments. Net gains on the sales of investments included a $1.25 billion gain on the sale of the Company’s share of Expedia. Interest and dividend income decreased $66 million from fiscal 2001 as a result of lower interest rates and dividend income.
      In fiscal 2001, other-than-temporary impairments primarily related to cable and telecommunication investments. Net gains from the sales of investments in fiscal 2001 included a gain from Microsoft’s investment in Titus Communications (which was merged with Jupiter Telecommunications) and the closing of the sale of Transpoint to CheckFree Holdings Corp. Interest and dividend income increased $591 million from fiscal 2000, reflecting a larger investment portfolio. In fiscal year 2000, investment income increased primarily as a result of a larger investment portfolio generated by cash from operations coupled with realized gains from the sale of securities.
      At June 30, 2002, unrealized losses on Equity and Other Investments of $623 million were deemed to be temporary in nature. The following, among other factors, could result in some investments being deemed other-than-temporarily impaired in future periods: changes in the duration and extent to which the fair value is less than cost; the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors; and the Company’s intent and ability to hold the investment.
      In connection with the definitive agreement to combine AT&T Broadband with Comcast in a new company to be called AT&T Comcast Corporation, Microsoft has agreed to exchange its AT&T 5% convertible preferred debt securities for approximately 115 million shares of AT&T Comcast Corporation. It is expected that the transaction will close by December 31, 2002. While it is possible that Microsoft could incur a loss on this exchange transaction up to the carrying value of the AT&T debt securities, management believes that the ultimate loss, if any, will be significantly less. As management is unable to predict whether there will be a gain or loss on the exchange, no loss has been recorded related to this contingent exchange transaction as of June 30, 2002.
      The Company’s effective tax rate for fiscal 2002 was 32%. The effective tax rate for fiscal 2001 and fiscal 2000 was 33% and 34%, respectively. The decrease in the effective tax rate is due primarily to lower taxes on foreign earnings.

ACCOUNTING CHANGES

Effective July 1, 2001, Microsoft adopted SFAS 141, Business Combinations, and SFAS 142, Goodwill and Other Intangible Assets. SFAS 141 requires business combinations to be accounted for using the purchase method of accounting. It also specifies the types of acquired intangible assets that are required to be recognized and reported separate from goodwill. SFAS 142 requires that goodwill and certain intangibles no longer be amortized, but instead tested for impairment at least annually. There was no impairment of goodwill upon adoption of SFAS 142. Goodwill amortization (on a pre-tax basis) was $234 million in fiscal 2000 and $311 million in fiscal 2001.
      Effective July 1, 2000, Microsoft adopted SFAS 133, Accounting for Derivative Instruments and Hedging Activities, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. The adoption of SFAS 133 resulted in a cumulative pre-tax reduction to income of $560 million ($375 million after-tax) and a cumulative pre-tax reduction to other comprehensive income (OCI) of $112 million ($75 million after-tax). The reduction to income was mostly attributable to a loss of approximately $300 million reclassified from OCI for the time value of options and a loss of approximately $250 million reclassified from OCI for derivatives not designated as hedging instruments. The reduction to OCI was mostly attributable to losses of approximately $670 million on cash flow hedges offset by the reclassifications out of OCI of the approximately $300 million loss for the time value of options and the approximately $250 million loss for derivative instruments not designated as hedging instruments.

FINANCIAL CONDITION

The Company’s cash and short-term investment portfolio totaled $38.65 billion at June 30, 2002. The portfolio consists primarily of fixed-income securities, diversified among industries and individual issuers. Microsoft’s investments are generally liquid and investment grade. The portfolio is invested predominantly in U.S. dollar denominated securities, but also includes foreign currency positions in order to diversify financial risk. The portfolio is primarily invested in short-term securities to minimize interest rate risk and facilitate rapid deployment for immediate cash needs.
     Cash flow from operations was $14.51 billion for fiscal 2002, an increase of $1.09 billion from fiscal 2001. The increase reflects strong growth in unearned revenue. Cash used for financing was $4.57 billion in fiscal 2002, a decrease of $1.01 billion from the prior year. The decrease reflects the repurchase of put warrants in the prior year. The Company repurchased 122.8 million shares of common stock under its share repurchase program in fiscal 2002, compared to 89.0 million shares repurchased in the prior year. In addition, 5.1 million shares of common stock were acquired in fiscal 2002 under a structured stock repurchase transaction. The Company entered into the structured stock repurchase transaction in fiscal 2001, giving it the right to acquire 5.1 million of its shares in exchange for an up-front net payment of $264 million. Cash used for investing was $10.85 billion in fiscal 2002, an increase of $2.11 billion from fiscal 2001.
      Cash flow from operations was $13.42 billion in fiscal 2001, an increase of $2.00 billion from the prior year. The increase was primarily attributable to the growth in revenue and other changes in working capital, partially offset by the decrease in the stock option income tax benefit, reflecting decreased stock option exercises by employees. Cash used for financing was $5.59 billion in fiscal 2001, an increase of $3.39 billion from the prior year. The increase primarily reflects the repurchase of put warrants in fiscal 2001, compared to the sale of put warrants in the prior fiscal year, as well as an increase in common stock repurchased. All outstanding put warrants were either retired or exercised during fiscal 2001. During fiscal 2001, the Company repurchased 89.0 million shares. Cash used for investing was $8.73 billion in fiscal 2001, a decrease of $658 million from the prior year. In fiscal 2000, cash flow from operations was $11.43 billion, a decrease of $720 million from the prior year, reflecting working capital changes partially offset by the increase in the stock option income tax benefit. Cash used for financing was $2.19 billion in fiscal 2000, an increase of $1.33 billion from the prior year, reflecting an increase in common stock repurchased versus the prior year. During fiscal 2000, the Company repurchased 55.2 million shares. Cash used for investing was $9.39 billion in fiscal 2000, a decrease of $808 million from the prior year.
      Microsoft has no material long-term debt. Stockholders’ equity at June 30, 2002 was $52.18 billion. Microsoft will continue to invest in sales, marketing, and product support infrastructure. Additionally, research and development activities will include investments in existing and advanced areas of technology, including using cash to acquire technology. Additions to property and equipment will continue, including new facilities and computer systems for R&D, sales and marketing, support, and administrative staff. Commitments for constructing new buildings were $111 million on June 30, 2002. The Company has not engaged in any transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to affect materially liquidity or the availability of or requirements for capital resources. Since fiscal 1990, Microsoft has repurchased 982 million common shares while 2.23 billion shares were issued under the Company’s employee stock option and purchase plans. The Company’s convertible preferred stock matured on December 15, 1999. Each preferred share was converted into 1.1273 common shares.
      Management believes existing cash and short-term investments together with funds generated from operations should be sufficient to meet operating requirements. The Company’s cash and short-term investments are available for strategic investments, mergers and acquisitions, other potential large-scale needs and to fund the share repurchase program. Microsoft has not paid cash dividends on its common stock.

SUBSEQUENT EVENT

On July 11, 2002, Microsoft acquired Navision a/s as a result of the successful close of a tender offer. Microsoft purchased Navision’s shares for approximately $1.45 billion in stock and cash. Navision is a provider of integrated business software solutions for small and medium-sized companies.

APPLICATION OF CRITICAL ACCOUNTING POLICIES

Microsoft’s financial statements and accompanying notes are prepared in accordance with generally accepted accounting principles in the United States. Preparing 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. Critical accounting policies for Microsoft include revenue recognition, impairment of investment securities, accounting for research and development costs, accounting for legal contingencies, and accounting for income taxes.
      Microsoft accounts for the licensing of software in accordance with American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 97-2, Software Revenue Recognition. The application of SOP 97-2 requires judgment, including whether a software arrangement includes multiple elements, and if so, whether vendor-specific objective evidence (VSOE) of fair value exists for those elements. End users receive certain elements of the Company’s products over a period of time. These elements include browser technologies updates and technical support, the fair value of which is recognized over the product’s estimated life cycle. Changes to the elements in a software arrangement, the ability to identify VSOE for those elements, the fair value of the respective elements, and changes to a product’s estimated life cycle could materially impact the amount of earned and unearned revenue. Judgment is also required to assess whether future releases of certain software represent new products or upgrades and enhancements to existing products.
      SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, and Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) 59, Accounting for Noncurrent Marketable Equity Securities, provide guidance on determining when an investment is other-than-temporarily impaired, which also requires judgment. In making this judgment, Microsoft evaluates, among other factors, the duration and extent to which the fair value of an investment is less than its cost; the financial health of and business outlook for the investee, including factors such as industry and sector performance, changes in technology, and operational and financing cash flow; and the Company’s intent and ability to hold the investment.
      Microsoft accounts for research and development costs in accordance with several accounting pronouncements, including SFAS 2, Accounting for Research and Development Costs, and SFAS 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed. SFAS 86 specifies that costs incurred internally in creating a computer software product should be charged to expense when incurred as research and development until technological feasibility has been established for the product. Once technological feasibility is established, all software costs should be capitalized until the product is available for general release to customers. Judgment is required in determining when the technological feasibility of a product is established. Microsoft has determined that technological feasibility for its products is reached shortly before the products are released to manufacturing. Costs incurred after technological feasibility is established are not material, and accordingly, the Company expenses all research and development costs when incurred.
      Microsoft is subject to various legal proceedings and claims, the outcomes of which are subject to significant uncertainty. SFAS 5, Accounting for Contingencies, requires that an estimated loss from a loss contingency should be 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. Disclosure of a contingency is required if there is at least a reasonable possibility that a loss has been incurred. The Company evaluates, 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 the Company’s financial position or its results of operations.
      SFAS 109, Accounting for Income Taxes, establishes financial accounting and reporting standards for the effect of 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. Judgment is required in assessing the future tax consequences of events that have been recognized in the Company’s financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences could materially impact the Company’s financial position or its results of operations.

ISSUES AND UNCERTAINTIES

The following issues and uncertainties, among others, should be considered in evaluating the Company’s financial outlook.

Challenges to the Company’s Business Model.     Since its inception, the Company’s business model has been based upon customers agreeing to pay a fee to license software developed and distributed by Microsoft. Under this commercial software development (“CSD”) model, software developers bear the costs of converting original ideas into software products through investments in research and development, offsetting these costs with the revenues received from the distribution of their products. The Company believes that the CSD model has had substantial benefits for users of software, allowing them to rely on the expertise of the Company and other software developers that have powerful incentives to develop innovative software that is useful, reliable and compatible with other software and hardware. In recent years, there has been a growing challenge to the CSD model, often referred to as the Open Source movement. Under the Open Source model, software is produced by global “communities” of programmers, and the resulting software and the intellectual property contained therein is licensed to end users at little or no cost. The Company believes that there are significant problems with the Open Source model, the principal drawback being that no single entity is responsible for the Open Source software, and thus users have no recourse if a product does not work properly or at all. Further, without the market incentives associated with the CSD model, the Company believes that the vigorous innovation and growth of the software industry over the last 25 years would not have occurred. Nonetheless, the popularization of the Open Source movement continues to pose a significant challenge to the Company’s business model, including recent efforts by proponents of the Open Source model to convince governments worldwide to mandate the use of Open Source software in their purchase and deployment of software products. To the extent the Open Source model gains increasing market acceptance, sales of the Company’s products may decline, the Company may have to reduce the prices it charges for its products, and revenues and operating margins may consequently decline.

New Products and Services. The Company has made significant investments in research and development for new products, services and technologies, including Microsoft .NET, Xbox, business applications, MSN, mobile and wireless technologies, and television. Significant revenue from these investments may not be achieved for a number of years, if at all. Moreover, these products and services may never be profitable, and even if they are profitable, operating margins for these businesses are not expected to be as high as the margins historically experienced in our Desktop and Enterprise Software and Services businesses.

Declines in Demand for Software.     If overall market demand for PCs, servers and other computing devices declines significantly, and consumer and corporate spending for such products declines, Microsoft’s revenue growth will be adversely affected. Additionally, the Company’s revenues would be unfavorably impacted if customers reduce their purchases of new software products or upgrades to existing products if such new offerings are not perceived to add significant new functionality or other value to prospective purchasers.

Product Development Schedule.     The development of software products is a complex and time-consuming process. New products and enhancements to existing products can require long development and testing periods. Significant delays in new product releases or significant problems in creating new products could negatively impact the Company’s revenues.

International Operations.     Microsoft develops and sells products throughout the world. The prices of the Company’s products in countries outside of the United States are generally higher than the Company’s prices in the United States because of the cost incurred in localizing software for non-U.S. markets. The costs of producing and selling the Company’s products in these countries also are higher. Pressure to globalize Microsoft’s pricing structure might require that the Company reduce the sales price of its software in other countries, even though the costs of the software continue to be higher than in the United States. Unfavorable changes in trade protection laws, policies and measures, and other regulatory requirements affecting trade and investment; unexpected changes in regulatory requirements for software; social, political, labor, or economic conditions in a specific country or region, including foreign exchange rates; difficulties in staffing and managing foreign operations; and potential adverse foreign tax consequences, among other factors, could also have a negative effect on the Company’s business and results of operations outside of the United States.

Intellectual Property Rights.     Microsoft diligently defends its intellectual property rights, but unlicensed copying and use of software represents a loss of revenue to the Company. While this adversely affects U.S. revenue, revenue loss is even more significant outside the United States, particularly in countries where laws are less protective of intellectual property rights. Throughout the world, Microsoft actively educates consumers on the benefits of licensing genuine products and educates lawmakers on the advantages of a business climate where intellectual property rights are protected. However, continued efforts may not affect revenue positively and further deterioration in compliance with existing legal protections or reductions in the legal protection for intellectual property rights of software developers could adversely affect revenue.

Taxation of Extraterritorial Income.     In August 2001, a World Trade Organization (“WTO”) dispute panel determined that the extraterritorial tax (“ETI”) provisions of the FSC Repeal and Extraterritorial Income Exclusion Act of 2000 constitute an export subsidy prohibited by the WTO Agreement on Subsidies and Countervailing Measures Agreement. The U.S. government appealed the panel’s decision and lost its appeal. On January 29, 2002, the WTO Dispute Settlement Body adopted the Appellate Body report. President Bush has stated the U.S. will bring its tax laws into compliance with the WTO ruling, but the Administration and Congress have not decided on a solution for this issue. In July 2002, Representative Bill Thomas, Chairman of the House Ways and Means Committee, introduced the American Competitiveness and Corporate Accountability Act of 2002. If enacted, that bill would repeal the ETI regime and introduce broad-based international reform. The proposed reforms would not materially affect the Company. On August 30, 2002, a WTO arbitration panel determined that the European Union may impose up to $4.04 billion per year in countermeasures if the U.S. rules are not brought into compliance. The WTO decision does not repeal the ETI tax benefit and it does not require the European Union to impose trade sanctions, so it is not possible to predict what impact the WTO decision will have on future results pending final resolution of these matters. If the ETI exclusion is repealed and replacement legislation is not enacted, the loss of tax benefit to the Company could be significant.

Litigation.     As discussed in Note 19—Contingencies of the Notes to Financial Statements, the Company is subject to a variety of claims and lawsuits. While the Company believes that none of the litigation matters in which the Company is currently involved will have a material adverse impact on the Company’s financial position or results of operations, it is possible that one or more of these matters could be resolved in a manner that would ultimately have a material adverse impact on the business of the Company, and could negatively impact its revenues and operating margins.