NOTE 14    EMPLOYEE STOCK AND SAVINGS PLANS

Effective July 1, 2003, we adopted the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, using the retroactive restatement method described in SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure. Under the fair value recognition provisions of SFAS No. 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 were restated for fiscal year 2003 to reflect results as if the fair-value method of SFAS No. 123 had been applied from its original effective date. Total compensation cost recognized in income for stock-based employee compensation awards was $3.75 billion in fiscal year 2003, $5.73 billion in fiscal year 2004, and $2.45 billion in fiscal year 2005. The amounts for fiscal year 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. 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 that became effective July 1, 2005. As a result, beginning in fiscal year 2005, shares of our common stock may presently be purchased by employees at three months intervals at 90% of the fair market value on the last day of each three month period. Employees may purchase shares having a value not exceeding 15% of their gross compensation during an offering period. During fiscal year 2005 employees purchased 16.4 million shares at an average price of $23.33 per share. At June 30, 2005, 159.1 million shares were reserved for future issuance.

Under the plan in effect previous to fiscal year 2005, 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 year 2003 and 2004 employees purchased 15.2 million and 16.7 million shares at average prices of $22.56, and $22.74 per share.

Savings Plan.     We have a savings plan in the United States, that qualifies under Section 401(k) of the Internal Revenue Code, and a number of savings plans in international locations. Participating U.S. employees may contribute up to 50% 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 $118 million, $141 million, and $154 million in fiscal years 2003, 2004, and 2005. 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 year 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 year 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.

Under the terms of the program, JPMorgan paid us $382 million for the 345 million options transferred. 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 two or three years following the transfer. 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 was recorded in the second quarter of fiscal year 2004. The contingent payments applicable to 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 year 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, 2005, an aggregate of 816 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 816 million shares remaining available for grant at June 30, 2005 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.

On November 9, 2004, our shareholders approved amendments to the stock plans that allowed our Board of Directors to adjust eligible options, unvested stock awards, and shared performance stock awards to maintain their pre-dividend value after the $3.00 special dividend. Additional awards were granted for options, stock awards, and shared performance stock awards by the ratio of post- and pre-special dividend stock price as of the ex-dividend date. Strike prices for options were decreased by the same ratio. Stock-based compensation was not affected by this adjustment. As a result of this approval and payment of the $3.00 special dividend on December 2, 2004, an adjustment to the prices and number of shares of existing awards was made resulting in a total of 96 million options and 6.7 million stock awards being issued to adjust the outstanding awards. In addition, the target shared performance stock awards were increased by 3.5 million shares.

Stock Awards and Shared Performance Stock Awards.     Stock awards are grants that entitle the holder to shares of common stock as the award vests. Our stock awards generally vest ratably over a five-year period.

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 following the end of the performance period and as the stock awards vest ratably over the following two years. Because these awards cover a three-year period, Shared Performance Stock Awards will only be awarded in fiscal year 2005 and 2006 to newly hired and promoted employees eligible to receive Shared Performance Stock Awards.

Stock Awards and Shared Performance Stock Awards are amortized over the vesting period (generally 5 years) using the straight line method.

The following activity has occurred under our existing plans:

(share amounts in millions)
Year Ended June 30	2004)		2005)
Stock awards
Beginning balance	3.9)		34.4)
Granted	32.6)		41.0)
Special dividend adjustment	–)		6.7)
Vested	(0.8)		(7.3)
Cancelled	(1.3)		(3.5)
Ending balance	34.4)		71.3)
Weighted-average fair value per share for shares granted during the year*	$24.09)		$24.03)
Shared performance stock awards
Beginning balance	–)		30.5)
Granted	31.7)		3.7)
Special dividend adjustment	–)		3.5)
Vested	–)		–)
Cancelled	(1.2)		(2.4)
Ending balance	30.5)		35.3)
Weighted-average fair value per share for shares granted during the year*	$23.62)		$24.35)

* Adjusted for additional awards granted for the $3.00 special dividend.

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, 2005, stock options for 662 million shares were vested.

The weighted average Black-Scholes value of options granted under the stock plans during fiscal year 2003 and 2004 was $12.08 and $10.13, respectively. No stock options were granted in fiscal 2005. 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	2003%		2004%
Weighted average expected life in years	7%		7%
Dividend per share	$0.08%		$0.16%
Volatility	42.0%		29.5%
Risk-free interest rate	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, 2002	1,604)		$00.400–0 $59.57		$26.88
Granted	254)		21.420–  0 29.12		24.27
Exercised	(234)		0.510–  0 28.22		6.89
Canceled/forfeited	(75)		2.130–  0 59.56		34.33
Balance, June 30, 2003	1,549)		0.400–  0 59.56		29.30
Granted	2)		25.460–  0 29.96		26.76
Exercised	(198)		0.510– 0  29.38		12.21
Stock option transfer program	(345)		33.030–  0 59.56		38.70
Canceled/forfeited	(59)		2.310–  0 58.28		31.29
Balance, June 30, 2004	949)		0.400–  0 59.56		29.26
Special dividend adjustment	96)		0.360– 0  53.61		26.68
Granted	–)		–		–
Exercised	(138)		3.390– 0  29.56		20.42
Canceled/forfeited	(43)		14.290–  0 58.28		28.89
Balance, June 30, 2005	864)		$00.360– 0$59.56		$27.41

For various price ranges, weighted average characteristics of outstanding employee stock options at June 30, 2005 are as follows:

(In millions, except per share amounts and years)
				Outstanding options				Exercisable options
Range of exercise prices		Shares		Remaining life (years)		Weighted average price		Shares		Weighted average price
$00.360–0$15.00		24		1.50		$08.81		24		$08.81
015.010–0025.00		276		6.56		22.15		136		22.31
025.010–0033.00		430		4.64		27.88		369		28.10
033.010–0041.00		125		3.22		39.42		124		39.43
041.010–0059.56		9		2.58		44.78		9		44.78
		864						662

As of June 30, 2005, 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 12. In addition, the tables above include in the total options outstanding 4.3 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 $170.87 and a weighted average exercise price of $13.68.