(in millions, except per share amounts)   Significant accounting policies Accounting principles  The financial statements are prepared on a basis consistent with U.S. generally accepted accounting principles and International Accounting Standards formulated by the International Accounting Standards Committee (IASC). Principles of consolidation  The financial statements include the accounts of Microsoft and its subsidiaries. Significant intercompany transactions and balances have been eliminated. Investments in 50% owned joint ventures are accounted for using the equity method; the Company’s share of joint ventures’ activities is reflected in other expenses. 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 include provisions for returns and bad debts and the length of product life cycles and buildings’ lives. Actual results may differ from these estimates. Foreign currencies  Assets and liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Translation adjustments resulting from this process are charged or credited to equity. Revenue, costs, and expenses are translated at average rates of exchange prevailing during the year. Gains and losses on foreign currency transactions are included in other expenses. Revenue recognition  Revenue is recognized when earned. Revenue from products licensed to original equipment manufacturers is recorded when OEMs ship licensed products while revenue from corporate and organization license programs is recorded when the user installs the product. Revenue from packaged product sales to distributors and resellers is recorded when related products are shipped. Maintenance and subscription revenue is recognized ratably over the contract period. Revenue attributable to significant support (technical support and unspecified enhancements such as service packs and Internet browser updates) is based on the price charged or derived value of the undelivered elements and is recognized ratably on a straight-line basis over the product’s life cycle. Costs related to insignificant obligations, which include telephone support for certain products, are accrued. Provisions are recorded for returns and bad debts. Research and development  Research and development costs are expensed as incurred. The current U.S. accounting rule, Statement of Financial Accounting Standards (SFAS) 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed, does not materially affect the Company. Telephone support  Telephone support costs are included in sales and marketing. Income taxes  Income tax expense includes U.S. and international income taxes, plus an accrual for U.S. taxes on undistributed earnings of international subsidiaries. Certain items of income and expense are not reported in tax returns and financial statements in the same year. The tax effect of this difference is reported as deferred income taxes. Tax credits are accounted for as a reduction of tax expense in the year in which the credits reduce taxes payable. Earnings per share  Earnings per share is computed on the basis of the weighted average number of common shares outstanding plus the effect of outstanding stock options using the "treasury stock" method and preferred shares using the "if-converted" method. Beginning in the second quarter of 1998, Microsoft will be required to report earnings per outstanding common share in addition to diluted earnings per share. Earnings per common share computed under the new pronouncement would have been $1.25, $1.85, and $2.87 while reported diluted earnings per share were $1.16, $1.71, and $2.63 in 1995, 1996, and 1997. Stock split  In December 1996, outstanding shares of common stock were split two-for-one. All share and per share amounts have been restated. Financial instruments  The Company considers all liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. Short-term investments generally mature between three months and five years from the purchase date. All cash and short-term investments are classified as available for sale and are recorded at market. Cost approximates market for all classifications of cash and short-term investments; realized and unrealized gains and losses were not material.     Publicly tradeable equity securities are recorded at market; unrealized gains and losses are reflected in stockholders’ equity. Property, plant, and equipment  Property, plant, and equipment is stated at cost and depreciated using the straight-line method over the shorter of the estimated life of the asset or the lease term, ranging from one to 30 years. Reclassifications  Certain reclassifications have been made for consistent presentation. Unearned revenue In fiscal 1996, Microsoft committed to integrating its Internet technologies, such as the Company’s Internet browser, Microsoft Internet Explorer, into existing products at no additional cost to its customers. Given this strategy and other support commitments such as telephone support, Internet-based technical support, and unspecified product enhancements, Microsoft recognizes approximately 20% of Windows operating systems revenue over the product life cycles, currently estimated at two years. The unearned portion of revenue from Windows operating systems was $425 million and $860 million at June 30, 1996 and 1997.     Since Office 97 is also tightly integrated with the rapidly evolving Internet, and subsequent delivery of new Internet technologies, enhancements, and other support is likely to be more than minimal, a ratable revenue recognition policy became effective for Office 97 licenses beginning in 1997. Approximately 20% of Office 97 revenue is recognized ratably over the estimated 18-month product life cycle. Unearned revenue associated with Office 97 totaled $300 million at June 30, 1997.     Unearned revenue also includes maintenance and other subscription contracts, including custom corporate license agreements. Financial risks The Company’s investment portfolio is diversified and consists primarily of short-term investment grade securities. At June 30, 1996 and 1997, approximately 38% and 31% of accounts receivable represented amounts due from 10 channel purchasers. One customer accounted for approximately 12%, 13%, and 12% of revenue while another customer accounted for approximately 12%, 8%, and 5% of revenue in 1995, 1996, and 1997.     Finished goods sales to international customers in Europe, Japan, and Australia are primarily billed in local currencies. Payment cycles are relatively short, generally less than 90 days. European manufacturing costs and international selling, distribution, and support costs are generally disbursed in local currencies. Local currency cash balances in excess of short-term operating needs are generally converted into U.S. dollar cash and short-term investments on receipt. Therefore, foreign exchange rate fluctuations generally do not create a risk of material balance sheet gains or losses. As a result, Microsoft’s hedging activities for balance sheet exposures have been minimal.     At June 30, 1997, the Company had contracts to deliver $500 million in a foreign currency, expiring July 1998, which hedge foreign exchange rate risk related to a foreign currency denominated investment.     Foreign exchange rates affect the translated results of operations of the Company’s foreign subsidiaries. The Company hedges a percentage of planned international revenue with purchased options. The notional amount of the options outstanding at June 30, 1997 was $2.1 billion. At June 30, 1997, the fair value and premiums paid for the options were not material.   Cash and short-term investments       june 30   1996 1997 Cash and equivalents:       Cash   $ 64 $ 246 Commercial paper   1,664 1,660 Money market preferreds   105 946 Certificates of deposit   768 854     Cash and equivalents   2,601 3,706 Short-term investments:       Municipal securities   1,357 571 Corporate notes and bonds   1,125 1,907 U.S. Treasury securities   1,591 1,513 Certificates of deposit   266 1,269     Short-term investments   4,339 5,260         Cash and short-term investments $6,940 $8,966 Property, plant, and equipment       june 30   1996 1997 Land   $ 183 $ 183 Buildings   787 1,027 Computer equipment   885 1,064 Other   491 503 Property, plant, and equipment - at cost 2,346 2,777 Accumulated depreciation   (1,020) (1,312) Property, plant, and equipment - net   $ 1,326 $ 1,465 During 1996 and 1997, depreciation expense, of which the majority related to computer equipment, was $363 million and $353 million; disposals were immaterial. Income taxes The provision for income taxes consisted of: year ended june 30 1995 1996 1997 Current taxes: U.S. and state $518 $1,139 $1,710 International 151 285 412     Current taxes 669 1,424 2,122 Deferred taxes 45 (240) (262)     Provision for income taxes $714 $1,184 $1,860 U.S. and international components of income before income taxes were: year ended june 30 1995 1996 1997 U.S. $1,549 $2,356 $3,775 International 618 1,023 1,539     Income before income taxes $2,167 $3,379 $5,314 Income taxes payable were: june 30 1996 1997 Deferred income tax assets: Revenue items $ 193 $ 474 Expense items 322 505     Deferred income tax assets 515 979 Deferred income tax liabilities: International earnings (261) (465) Other (6) (4)     Deferred income tax liabilities (267) (469) Current income tax liabilities (732) (976)     Income taxes payable $(484) $(466) Income taxes have been settled with the Internal Revenue Service for all years through 1989. The IRS has assessed taxes for 1990 and 1991 that the Company is contesting in Tax Court. The IRS is examining the Company’s U.S. income tax returns for 1992 through 1994. Management believes any related adjustments that might be required will not be material to the financial statements. Income taxes paid were $430 million, $758 million, and $1.1 billion in 1995, 1996, and 1997. Convertible preferred stock During December 1996, Microsoft issued 12.5 million shares of 2.75% convertible exchangeable principal-protected preferred stock. Dividends are payable quarterly in arrears. Preferred shareholders have preference over common stockholders in dividends and liquidation rights. In December 1999, each preferred share is convertible into common shares or an equivalent amount of cash determined by a formula that provides a floor price of $79.875 and a cap of $102.24 per preferred share. Net proceeds of $980 million were used to repurchase common shares. Common stock Shares of common stock outstanding were as follows: year ended june 30 1995 1996 1997 Balance, beginning of year 1,162 1,176 1,194 Issued 38 44 47 Repurchased (24) (26) (37) Balance, end of year 1,176 1,194 1,204 The Company repurchases its common stock in the open market to provide shares for issuing to employees under stock option and stock purchase plans. The Company’s Board of Directors authorized continuation of this program in 1998. Put warrants To enhance its stock repurchase program, the Company sells put warrants to independent third parties. These put warrants entitle the holders to sell shares of Microsoft common stock to the Company on certain dates at specified prices. On June 30, 1996 and 1997, 13.0 million and 3.0 million warrants were outstanding. Outstanding put warrants at June 30, 1997 expire in September 1997 and have strike prices of $105 per share. At June 30, 1996, the outstanding put warrants were settleable in cash at Microsoft’s option thus resulting in a reclassification of the maximum potential repurchase obligation of $635 million from stockholders’ equity to put warrants. The outstanding put warrants at June 30, 1997 permitted a net-share settlement at the Company’s option and did not result in a put warrant liability on the balance sheet. Employee stock and savings plans Employee stock purchase plan  The Company has an employee stock purchase plan for all eligible employees. Under the plan, shares of the Company’s common stock may 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 may purchase shares having a value not exceeding 10% of their gross compensation during an offering period. During 1995, 1996, and 1997, employees purchased 2.1 million, 1.8 million, and 1.4 million shares at average prices of $23.38, $37.72, and $59.64 per share. At June 30, 1997, 19.4 million shares were reserved for future issuance. Savings plan  The Company has a savings plan, which qualifies under Section 401(k) of the Internal Revenue Code. Participating employees may defer up to 15% of pretax salary, but not more than statutory limits. The Company contributes fifty cents for each dollar a participant contributes, with a maximum contribution of 3% of a participant’s earnings. Matching contributions were $12 million, $15 million, and $28 million in 1995, 1996, and 1997. Stock option plans   The Company has stock option plans for directors, officers, and all employees, which provide for nonqualified and incentive stock options. The option exercise price is the fair market value at the date of grant. Options granted prior to 1995 generally vest over four and one-half years and expire 10 years from the date of grant. Options granted during and after 1995 generally vest over four and one-half years and expire seven years from the date of grant, while certain options vest over seven and one-half years and expire after 10 years. At June 30, 1997, options for 113 million shares were vested and 290 million shares were available for future grants under the plans. Stock options outstanding were as follows: Price per share Shares Range Weighted Average Balance, June 30, 1994 228 $ 0.16 - $ 25.07 $ 11.65 Granted 44 23.88 - 41.57 25.25 Exercised (35) 0.16 - 23.88 7.91 Canceled (9) 2.56 - 37.50 17.70 Balance, June 30, 1995 228 0.77 - 41.57 14.56 Granted 57 40.10 - 58.94 44.99 Exercised (40) 0.77 - 45.25 10.75 Canceled (7) 2.59 - 55.44 27.85 Balance, June 30, 1996 238 1.10 - 58.94 22.07 Granted 55 55.31 - 119.19 58.29 Exercised (45) 1.10 - 58.94 13.27 Canceled (9) 17.00 - 97.13 38.83 Balance, June 30, 1997 239 2.24 - 119.19 31.43 For various price ranges, weighted average characteristics of outstanding stock options at June 30, 1997 were as follows: Outstanding options Exercisable options Range of exercisable prices Shares Remaining life (years) Weighted average price Shares Weighted average price $ 2.24 - $ 17.00 65 3.5 $ 9.64 64 $ 9.63  17.01 - 24.00 65 5.4 20.81 39 20.10 24.01 - 55.00 56 5.8 43.13 10 41.02 55.01 - 119.19 53 6.6 58.47 - - The Company follows APB Opinion 25, Accounting for Stock Issued to Employees, to account for stock option and employee stock purchase plans. No compensation cost is recognized because the option exercise price is equal to the market price of the underlying stock on the date of grant. Had compensation cost for these plans been determined based on the Black-Scholes value at the grant dates for awards as prescribed by SFAS Statement 123, Accounting for Stock-Based Compensation, pro forma net income and earnings per share would have been: year ended june 30 1995 1996 1997 Pro forma net income $1,243 $1,902 $3,053 Pro forma earnings per share $  0.99 $  1.48 $  2.32 The pro forma disclosures above include the amortization of the fair value of all options vested during 1995, 1996, and 1997. If only options granted during 1996 and 1997 were valued, as prescribed by SFAS 123, pro forma net income would have been $2,073 million and $3,179 million, and earnings per share would have been $1.62 and $2.42 for 1996 and 1997.     The weighted average Black-Scholes value of options granted under the stock option plans during 1995, 1996, and 1997 was $10.46, $17.72, and $23.43. Value was estimated using an expected life of five years, no dividends, volatility of .30, and risk-free interest rates of 7.0%, 6.0%, and 6.5% in 1995, 1996, and 1997. MSN, The Microsoft Network During October 1996, Microsoft and a subsidiary of Tele-Communications, Inc. (TCI) terminated a partnership under which TCI owned a 20% minority interest in The Microsoft Network, LLC, owner of the business assets of MSN, an online service. Due to the evolving nature of the online industry and the move by MSN to a Web-based offering, the original direction of the partnership changed and both Microsoft and TCI agreed to terminate this partnership focused exclusively on MSN. In return for approximately $125 million of TCI securities, Microsoft became the sole owner of MSN and the minority interest on the accompanying balance sheet was eliminated. There was no other material financial impact of the dissolution. Acquisition On August 1, 1997, the Company acquired WebTV Networks, Inc. (WebTV), an online service that enables consumers to experience the Internet through their televisions via set-top terminals based on proprietary technologies. A director of the Company owned 10% of WebTV. Microsoft paid $425 million in stock and cash for WebTV. The Company expects to record an in-process R&D write-off of $300 million in the first quarter of 1998. Commitments and contingencies The Company has operating leases for most U.S. and international sales and support offices and certain equipment. Rental expense for operating leases was $86 million, $92 million, and $92 million in 1995, 1996, and 1997. Future minimum rental commitments under noncancelable leases, in millions of dollars, are: 1998, $67; 1999, $54; 2000, $43; 2001, $30; 2002, $12; and thereafter, $16.     In connection with the Company’s communications infrastructure and the operation of MSN, Microsoft has certain communication usage commitments. Future related minimum commitments, in millions of dollars, are: 1998, $133; 1999, $119; 2000, $92; and 2001, $20. Also, Microsoft has committed to certain volumes of outsourced telephone support and manufacturing of packaged product and has committed $300 million for constructing new buildings.    During 1996, Microsoft and National Broadcasting Company (NBC) established two MSNBC joint ventures: a 24-hour cable news and information channel and an interactive online news service. Microsoft agreed to pay $220 million over a five-year period for its interest in the cable venture, to pay one-half of operational funding of both joint ventures for a multiyear period, and to guarantee a portion of MSNBC debt.     In an ongoing investigation, the Antitrust Division of the U.S. Department of Justice requested information from Microsoft concerning various issues. Microsoft is also subject to various legal proceedings and claims that arise in the ordinary course of business. Management currently believes that resolving these matters will not have a material adverse impact on the Company’s financial position or its results of operations. Geographic information year ended june 30 1995 1996 1997 Revenue U.S. operations $ 4,495 $ 6,739 $ 8,877 European operations 1,607 2,215 2,770 Other international operations 821 1,267 1,757 Eliminations (986) (1,550) (2,046)     Total revenue $ 5,937 $ 8,671 $11,358 Operating income U.S. operations $ 1,414 $ 2,137 $ 3,733 European operations 444 649 1,013 Other international operations 163 297 469 Eliminations 17 (5) (85)     Total operating income $ 2,038 $ 3,078 $ 5,130 Identifiable assets U.S. operations $ 5,862 $ 8,193 $11,630 European operations 1,806 2,280 3,395 Other international operations 689 1,042 705 Eliminations (1,147) (1,422) (1,343)     Total identifiable assets $ 7,210 $10,093 $14,387 Intercompany sales between geographic areas are accounted for at prices representative of unaffiliated party transactions. "U.S. operations" include shipments to customers in the United States, licensing to OEMs, and exports of finished goods directly to international customers, primarily in Asia, South America, and Canada. Exports and international OEM transactions are primarily in U.S. dollars and totaled $1.3 billion, $2.1 billion, and $2.5 billion in 1995, 1996, and 1997.     "Other international operations" primarily include subsidiaries in Japan, Canada, Australia, and Brazil. International revenue, which includes European operations, other international operations, exports, and OEM distribution, was 55%, 56%, and 56% of total revenue in 1995, 1996, and 1997. Most international identifiable assets are U.S. dollar denominated investment securities. Quarterly information (unaudited) quarter ended sept. 30 dec. 31 mar. 31 june 30 year 1995 Revenue $1,247 $ 1,482 $ 1,587 $ 1,621 $ 5,937 Operating income 437 520 549 532 2,038 Net income 316 373 396 368 1,453 Earnings per share 0.25 0.30 0.32 0.29 1.16 Common stock price per share: High 29.63 32.56 37.06 46.19 46.19 Low 23.44 26.94 29.13 34.38 23.44 1996 Revenue $ 2,016 $ 2,195 $ 2,205 $ 2,255 $ 8,671 Operating income 708 786 774 810 3,078 Net income 499 575 562 559 2,195 Earnings per share 0.39 0.45 0.44 0.43 1.71 Common stock price per share: High 54.63 51.69 53.53 62.94 62.94 Low 42.50 40.19 39.94 49.81 39.94 1997 Revenue $2,295 $2,680 $ 3,208 $ 3,175 $11,358 Operating income 902 1,081 1,568 1,579 5,130 Net income 614 741 1,042 1,057 3,454 Earnings per share 0.47 0.57 0.79 0.80 2.63 Common stock price per share: High 69.31 86.13 103.50 134.94 134.94 Low 53.75 65.44 80.75 89.75 53.75 The Company’s common stock is traded on The Nasdaq Stock Market under the symbol MSFT. On July 31, 1997, there were 53,390 holders of record of the Company’s common stock. The Company has not paid cash dividends on its common stock.    Last Updated: September 29, 1997 © 1997 Microsoft Corporation. All rights reserved. Terms of use.