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Effective July 1, 2003, we adopted the fair value recognition provisions of SFAS 123, Accounting for Stock-Based Compensation, using the retroactive restatement method described in SFAS 148, Accounting for Stock-Based Compensation - Transition and Disclosure. Under the fair value recognition provisions of SFAS 123, stock-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense over the vesting period. In connection with the use of the retroactive restatement method, income statement amounts have been restated for fiscal 2002 and 2003 to reflect results as if the fair-value method of SFAS 123 had been applied from its original effective date. Total compensation cost recognized in income for stock-based employee compensation awards was $3.78 billion in fiscal 2002, $3.75 billion in fiscal 2003, and $5.73 billion in fiscal 2004. The amounts for fiscal 2004 include $2.21 billion ($1.48 billion after-tax or $0.14 per diluted share) due to the completion of the employee stock option transfer program.

Employee Stock Purchase Plan.    We have an employee stock purchase plan for all eligible employees. Under the plan, shares of our common stock could be purchased at six month intervals at 85% of the lower of the fair market value on the first or the last day of each six month period. Employees could purchase shares having a value not exceeding 15% of their gross compensation during an offering period. During fiscal 2002, 2003, and 2004 employees purchased 10.8 million shares, 15.2 million shares, and 16.7 million shares at average prices of $25.26, $22.56, and $22.74 per share. At June 30, 2004, 175.5 million shares were reserved for future issuance.

During the fourth quarter of fiscal 2004, the administrative committee under the plan approved a change to the common stock purchase discount and approved the elimination of the related look back period and a change to quarterly purchase periods. As a result, effective beginning in fiscal 2005, shares of our common stock may be purchased by employees at three months intervals at 90% of the fair market value on the last day of each three month period.

Savings Plan.    We have a savings plan in the United States, that qualifies under Section 401(k) of the Internal Revenue Code, as well as a number of savings plans in international locations. Participating U.S. employees may contribute up to 25% of their pretax salary, but not more than statutory limits. We contribute fifty cents for each dollar a participant contributes in this plan, with a maximum contribution of 3% of a participant's earnings. Matching contributions for all plans were $101 million, $118 million, and $141 million in fiscal 2002, 2003, and 2004. Matching contributions are invested proportionate to each participant's voluntary contributions in the investment options provided under the plan. Investment options in the U.S. plan include Microsoft common stock, but neither participant nor our matching contributions are required to be invested in Microsoft common stock.

Stock Plans.    In fiscal 2004 we implemented changes in employee compensation designed to help us continue to attract and retain the best employees, and to better align employee interests with those of our shareholders.

In fiscal 2004, we began granting employees stock awards instead of stock options. The stock award program offers employees the opportunity to earn shares of our stock over time, rather than options that give employees the right to purchase stock at a set price. We also completed an employee stock option transfer program in the second quarter of fiscal 2004 whereby employees could elect to transfer all of their vested and unvested stock options with a strike price of $33 or higher ("eligible options") to JPMorgan. The unvested eligible options that were transferred to JPMorgan became vested upon the transfer. The price paid by JPMorgan for the transferred options was determined by reference to the arithmetic average of the closing prices of Microsoft common stock during the period from November 14, 2003 to December 8, 2003, which was $25.57.

A total of 18,503 (51%) of the 36,539 eligible employees elected to participate in the stock option transfer program and 344.6 million (55%) of the 621.4 million eligible options were tendered. Under the terms of the program, JPMorgan paid us $382 million for the transferred options. We made an initial payment of $219 million to participating employees for the transferred options, with a remaining portion to be paid in one or more payments that are subject to participating employees' continued employment over the next two or three years. The options that were transferred to JPMorgan resulted in stock-based compensation expense of $2.21 billion ($1.48 billion after-tax or $0.14 per diluted share) which is reflected in the results of fiscal 2004. This expense consists of the unrecognized compensation costs of the options that were transferred, less the amounts payable applicable to those previously unvested options for which payment is contingent upon continued employment of participating employees. The contingent payments applicable to unvested eligible options that are subject to continued employment of participating employees will be recognized as compensation expense over the vesting period of the contingent payments.

The stock option transfer program also resulted in a decrease to our long-term deferred tax assets due to the excess of recorded compensation expense for these options over the related tax deduction reported on our tax return. For fiscal 2004, deferred tax assets were reduced by approximately $2.01 billion with an offsetting reduction in paid-in capital, reflecting the reduction of previously recorded deductions reported on our tax return in excess of stock based compensation expense. A description of our stock plans follows.

We have stock plans for directors and for officers, employees, consultants and advisors. The plans provide for awards of stock options and stock awards. At June 30, 2004, an aggregate of 807 million shares were available for future grant under our stock plans. Our plans under which awards may be issued do not contain separate limitations on the number of stock awards; all 807 million shares remaining available for grant at June 30, 2004 could be awarded as stock awards. In addition, awards that expire or are cancelled without delivery of shares generally become available for issuance under the plans. The options transferred to JPMorgan have been removed from our plans; any options transferred to JPMorgan that expire without being exercised will not become available for grant under any of our plans.

Stock Awards and Shared Performance Stock Awards.    Stock awards are grants that entitle the holder to shares of common stock as the award vests. During fiscal 2004, 32.6 million stock awards with a weighted-average fair value of $26.12 per share were granted and generally vest ratably over a five-year period. Approximately 787,000 stock awards vested and 1.1 million stock awards were cancelled during fiscal 2004.

Shared Performance Stock Awards are a form of stock award in which the number of shares ultimately received depends on our performance against specified performance targets. The performance period is July 1, 2003 through June 30, 2006 (January 1, 2004 through June 30, 2006 for certain executive officers). At the end of the performance period, the number of shares of stock and stock awards issued will be determined by adjusting upward or downward from the target in a range between 33% and 150% (0% to 150% for certain executive officers). The final performance percentage on which the payout will be based, considering performance metrics established for the performance period, will be determined by the board of directors or a committee of the board in its sole discretion. Shares of stock will be issued at the end of the performance period and as the stock awards vest ratably over the following two years. In fiscal 2004, Shared Performance Stock Awards representing the targeted number of shares for the performance period ending June 30, 2006 were granted in the aggregate amount of 31.7 million shares with a weighted average fair value of $26.08 per share. Because these awards cover a three-year period, Shared Performance Stock Awards will only be awarded in fiscal 2005 and 2006 to newly hired and promoted employees eligible to receive Shared Performance Stock Awards. No shared performance stock awards vested and 1.2 million shared performance stock awards were cancelled during fiscal 2004.

Stock Awards and Shared Performance Stock Awards are amortized over 5 years using the straight line method.

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Stock Options.    Nonqualified stock options have been granted to our directors under our non-employee director stock plans. Nonqualified and incentive stock options have been granted to our officers and employees under our employee stock plans. Options granted before 1995 generally vest over four and one-half years and expire ten years from the date of grant. Options granted between 1995 and 2001 generally vest over four and one-half years and expire seven years from the date of grant, while certain options vest either over four and one-half years or over seven and one-half years and expire ten years from the date of grant. Options granted after 2001 vest over four and one-half years and expire ten years from the date of grant. At June 30, 2004, stock options for 569 million shares were vested.

The weighted average Black-Scholes value of options granted under the stock plans during fiscal 2002, 2003, and 2004 was $15.79, $12.08, and $10.13, respectively. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants:

Year Ended June 30 2002   2003   2004
Weighted average expected life in years 7   7   7
Dividend per share $3900 -   $0.08   $0.16
Volatility 39.0%   42.0%   29.5%
Risk-free interest rate 5.4%   3.9%   4.1%


Employee stock options outstanding are as follows:

(In millions, except per share amounts)
  Price per share
  Shares   Range   Weighted average
Balance, June 30, 2001 1,796   $0.28 - $59.57   $24.77
   Granted 82   24.31 - $36.29   31.25
   Exercised (198)   0.51 - $34.91   6.41
   Canceled (76)   0.58 - $58.28   34.34
Balance, June 30, 2002 1,604   0.40 - $59.57   26.88
   Granted 254   21.42 - $29.12   24.27
   Exercised (234)   0.51 - $28.22   6.89
   Canceled (75)   2.13 - $59.56   34.33
Balance, June 30, 2003 1,549   0.40 - $59.56   29.30
   Granted 2   25.46 - $29.96   26.76
   Exercised (198)   0.51 - $29.38   12.21
   Stock Option Transfer Program (345)   33.03 - $59.56   38.70
   Canceled (59)   2.31 - $58.28   31.29
Balance, June 30, 2004 949   $0.40 - $59.56   $29.26


For various price ranges, weighted average characteristics of outstanding employee stock options at June 30, 2004 are as follows:

(In millions, except per share amounts)
  Outstanding options   Exercisable options
Range of exercise prices   Shares   Remaining
life (years)
average price
  Shares   Weighted
average price
$ 0.00 - $15.00   37   1.82   $46.60   36   $46.53
15.01 - $25.00   244   7.24   23.33   75   21.78
25.01 - $33.00   387   5.62   28.24   237   28.17
33.01 - $41.00   169   4.17   34.22   127   34.25
41.01 - $59.56   112   4.40   44.80   94   44.66
  949   569  


As of June 30, 2004, 345 million transferred options to JP Morgan remained outstanding and are excluded from the amounts noted as employee options outstanding in the tables above. See Note 11. In addition, the tables above include in the total options outstanding 6.8 million options outstanding that were granted in conjunction with corporate acquisitions. These options are included in the option totals; however, they are excluded from the exercise price ranges presented. These options had an exercise price range of $0.00 to $204.09 and a weighted average exercise price of $14.13.